Explain the following as factors affecting the choice of Capital structure.
(i) Cash flow position
(ii) Cost of equity
(iii) Floatation costs
(iv) Stock market conditions
Factors affecting capital structure :
(i)Cost of debt If the rate of interest on debt is high, the company should use less debt in its capital structure, and vice-versa.
(ii) Cost of equity When a company increases debt, the financial risk faced by equity shareholders increases. Thus, debt can be used upto a limit. Beyond that point, cost of equity may go up and share prices may decrease.
(iii) Interest coverage ratio ICR refers to the no. of times earnings before interest and tax covers the interest obligation. Higher the ICR, the company can borrow more funds and vice-versa.
(iv) Debt service coverage ratio It refers to the ratio that takes care of deficiencies in the ICR. A higher DSCR indicates better ability of the company to meet its cash commitments and borrow more funds.