Under the capital structure, the decision regarding the proportion of long-term sources of capital is determined. The most favorable proportion determines the optimum capital structure. That happens to be the need of the company because EPS happens to be the maximum on it. Some of the chief factors affecting the choice of the capital structure are the following:
(1) Cash Flow Position
While making a choice of the capital structure the future cash flow position should be kept in mind. Debt capital should be used only if the cash flow position is really good because a lot of cash is needed in order to make payment of interest and refund of capital.
(2) Interest Coverage Ratio-ICR
With the help of this ratio, an effort is made to find out how many times the EBIT is available for the payment of interest. The capacity of the company to use debt capital will be in direct proportion to this ratio.
It is possible that in spite of better ICR the cash flow position of the company may be weak. Therefore, this ratio is not a proper or appropriate measure of the capacity of the company to pay interest. It is equally important to take into consideration the cash flow position.
(3) Debt Service Coverage Ratio-DSCR
This ratio removes the weakness of ICR. This shows the cash flow position of the company.
This ratio tells us about the cash payments to be made (e.g., preference dividend, interest, and debt capital repayment) and the amount of cash available. A better ratio means a better capacity of the company for debt payment. Consequently, more debt can be utilized in the capital structure.
(4) Return on Investment-ROI
The greater return on investment of a company increases its capacity to utilize more debt capital.
(5) Cost of Debt
The capacity of a company to take debt depends on the cost of debt. In case the rate of interest on the debt capital is less, more debt capital can be utilized and vice versa.
(6) Tax Rate
The rate of tax affects the cost of debt. If the rate of tax is high, the cost of debt decreases. The reason is the deduction of interest on the debt capital from the profits considering it a part of expenses and a saving in taxes.
(7) Cost of Equity Capital
The cost of equity capital (it means the expectations of the equity shareholders from the company) is affected by the use of debt capital. If the debt capital is utilized more, it will increase the cost of the equity capital. The simple reason for this is that the greater use of debt capital increases the risk of the equity
(8) Floatation Costs
Floatation costs are those expenses that are incurred while issuing securities (e.g., equity shares, preference shares, debentures, etc.). These include the commission of underwriters, brokerage, stationery expenses, etc. Generally, the cost of issuing debt capital is less than the share capital. This attracts the company towards debt capital.
(9) Risk Consideration:
There are two types of risks in business –
(i) Operating Risk or Business Risk- This refers to the risk of inability to discharge permanent operating costs (e.g., rent of the building, payment of salary, insurance installment, etc.).
(ii) Financial Risk- This refers to the risk of inability to pay fixed financial payments (e.g., payment of interest, preference dividend, the return of the debt capital, etc.) as promised by the company.
According to this principle, the capital structure should be fairly flexible. Flexibility means that, if need be, the amount of capital in the business could be increased or decreased easily. Reducing the amount of capital in business is possible only in case of debt capital or preference share capital.
According to this factor, at the time of preparing the capital structure, it should be ensured that the control of the existing shareholders (owners) over the affairs of the company is not adversely affected.
If funds are raised by issuing equity shares, then the number of the company’s shareholders will increase and it directly affects the control of existing shareholders. In other words, now the number of owners (shareholders) controlling the company increases.
(12) Regulatory Framework
Capital structure is also influenced by government regulations. For instance, banking companies can raise funds by issuing share capital alone, not any other kind of security. Similarly, it is compulsory for other companies to maintain a given debt-equity ratio while raising funds.
(13) Stock Market Conditions
Stock market conditions refer to upward or downward trends in the capital market. Both these conditions have their influence on the selection of sources of finance. When the market is dull, investors are mostly afraid of investing in the share capital due to the high risk.
(14) Capital Structure of Other Companies
Capital structure is influenced by the industry to which a company is related. All companies related to a given industry produce almost similar products, their costs of production are similar, they depend on identical technology, they have similar profitability, and hence the pattern of their capital structure is almost similar.