Question

Explain briefly any four factors which affect the choice of capital structure of a company.

Answer 1

Factors affecting the choice of capital structure of a company:

• Cash flow: Debt should be opted by the company only if it has a strong cash flow position. This is because cash would be required to repay the principal along with the interest rate on the debt.
• Debt-service coverage ratio (DSCR): It depicts the cash payment obligations of a company as against its availability of cash. In case DSCR is high, the company can opt for more debt.
• Equity cost: The cost of equity depicts the financial risk faced by the company. If the financial risk is higher, then the shareholders expect a higher return. This, in turn, implies a rise in the cost of equity. However, if the cost of equity is high, then it would be difficult for the company to opt for more equity
• The condition of the stock market: In situations of good stock market conditions, the company can easily opt for equity capital and vice versa.