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Question
Explain briefly any four factors which affect the choice of capital structure of a company.
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Solution
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.
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Sunrises Ltd. dealing in readymade garments, is planning to expand its business operations in order to cater to international market. For this purpose the company needs additional Rs. 80,00,000 for replacing machines with modern machinery of higher production capacity. The company wishes to raise the required funds by issuing debentures. The debt can be issued at an estimated cost of 10%. The EBIT for the previous year of the company was Rs. 8,00,000 and total capital investment was Rs. 1,00,00,000. Suggest whether issue of debenture would be considered a rational decision by the company. Give reason to justify your answer. (Ans. No, Cost of Debt (10%) is more than ROI which is 8%).
Answer the following question.
'Determining the overall cost of capital and the financial risk of the enterprise depends upon various factors.' Explain any six such factors.
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ICR = ______
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When the proportion of debt and equity is such that it results in an increase in the value of equity share the ______ is/are said to be optimal.
______ refers to the increase in profit earned by the equity shareholders due to the presence of fixed financial charges like interest.
The Board of directors of Medex Pharma Ltd. decided to issue debentures worth ₹ 40 lakhs in order to finance a major Research and Development project. This would increase the Debt Equity ratio from 1:1 to 2:1.However, at the same time it would increase the Earnings per share.
The reason that will justify the above situation is ______.
