Factors that Influence a Company's Capital-Structure Decision

Corporate Finance

    Factors that Influence a Company's Capital-Structure Decision

  • Cash Flow Position

           During selecting the method of capital structure the investor should give attention on the future cash flow position. Debt capital should be used only if the cash flow position is good because a lot of cash is needed in order to make payment of interest and refund of capital.

    Interest Coverage Ratio-ICR

       ICR is used to find out how many times the EBIT is available to 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. 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.

     Return on Investment-ROI

        The greater return on investment of a company increases its capacity to utilize more debt capital.

    Cost of Debt

           The strength 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.

    Risk Consideration

    Operating Risk or Business Risk

           Business Risk means inability to discharge permanent operating costs (e.g., rent of the building, payment of salary, insurance installment, etc),

    Financial Risk

       It means inability to pay financial payments (e.g., payment of interest, preference dividend, return of the debt capital, etc.) as promised by the company.

    Stock Market Conditions

       Stock market condition means increasing or decreasing share rate in the capital market. Changes in the share rate influence on the selection of finance. When the share market is down investors are mostly afraid of investing in the share capital due to high risk. On the otherhand when conditions in the capital market are good they treat investment in the share capital as the best choice to reap profits. Companies should make selection of capital sources keeping in view the conditions prevailing in the capital market.

    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.

         Different ideal debt-equity ratios such as 2:1; 4:1; 6:1 have been determined for different industries. The public issue of shares and debentures has to be made under SEBI guidelines.



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