September 19, 2019

What are the factors that determine the capital structure?

  1. Financial leverage or trading on equity
    1. The use of long term debt increases, magnifies the EPS if the firm yields a return higher than the cost of debt. 
    2. The EPS also increases with the use of preference share capital but due to the fact that interest is allowed to be deducted while computing tax.
  2. Growth and stability of sales
    1. If the sales of a firm are expected to remain fairly stable, it can raise a higher level of debt. 
  3. Cost of capital
    1. Cost of capital depends on the risk suppliers have to undertake. 
    2. Objective is to minimize cost of capital. 
    3. Debt is preferred over preference share capital and equity due to low cost (low risk)
  4. Minimisation of risk
  5. Control
    1. Controlling hands in the company – equity shares risky compared to preference shares and debts. 
  6. Flexibility
    1. Ability to adjust its capital structure to the requirements of changing conditions. 
    2. Depends on unused debt capacity, terms of redemption, flexibility in fixed charges and restrictive stipulation in loan agreements. 
  7. Profitability 
    1. Maximum debt financing is generally cheaper. 
  8. Cash flow ability
    1. Ability to generate cash flow to service fixed charges
  9. Characteristics of the company
    1. Size, nature, credit standing etc. 
    2. Sales, competition, lifecycle

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