Question

State any four factors affecting the decision that determines the overall capital and the financial risk of the enterprise.

State any four factors affecting the financial decision that is concerned with raising of finance using shareholders’ funds and borrowed funds.

Explain the following as factor affecting 'Financing Decision':

Fixed operating costs

Explain the following as factor affecting 'Financing Decision':

Cash flow position of the company 

Answer 1

Following are the factors affecting capital structure of a company:

1. Size of the projected Cash flows must be considered before borrowing. 
2. Interest Coverage Ratio refers to the number of times earnings before interest and taxes of a company covers the interest obligation. 
3. Debt Service Coverage Ratio takes care of the deficiencies referred to in the interest coverage ratio.
4. More debt can be used if debt can be raised at a lower rate.
5. A higher Tax Rate makes debt relatively cheaper and increases its attraction vis-a-vis equity.
6. Process of raising resources also involves some cost which may affect the choice between debt and equity and hence capital structure.
7. If a firm’s business risk is lower, its capacity to use debt is higher and vice versa.
8. To maintain flexibility the firm must maintain some borrowing power to take care of unforeseen circumstances.

OR

Factors affecting financing decision: 

1. Cost: The cost of acquiring funding from various sources varies. A wise manager will go with the cheapest option.
2. Risk: The risk associated with various sources of funding varies. Borrowed money carry more risk than owner's funds because fixed interest must be paid and redeemed after a set period of time.
3. Flotation Cost: Flotation expenses are the costs associated with issuing securities, such as broker commissions, underwriters' fees, and so on. The higher the cost of floating, the less appealing the source of capital.
4. Cash flow position of the company: Since principal and interest payments may be made with ease, debt financing may be more practical than equity capital for a business with a stronger cash flow situation. Healthy financial management is indicated by positive cash flow, while possible difficulties may be indicated by negative cash flow. 
5. Fixed Operating Costs: Fixed operating costs refer to expenses such as building rent, insurance premiums, and salaries that remain constant regardless of production levels. For businesses with significant fixed operating costs, adopting less debt financing can reduce fixed finance costs and interest. Similarly, lower fixed operating costs might lead to increased debt financing.
6. Control Considerations: If existing shareholders want to retain complete management control, borrow funds; if they are willing to give up control of the business, equity might be used to raise capital.
7. State of Capital Markets: The financial market conditions also influence the source of funds. If the capital market is rising, finance can be easily raised by issuing shares; nevertheless, during a downturn, issuing equity shares is difficult.