FACTORS THAT INFLUENCE A COMPANY’S CAPITAL-STRUCTURE DECISION:
The capital structure of a company is a particular combination of debt, equity and other sources of finance that it uses to fund its long-term asset. The key division in capital structure is between debt and equity. The proportion of debt funding is measured by gearing or leverages. There are different factors that affect a firm’s capital structure, and a firm should attempt to determine what its optimal or best mix of financing.
The firm’s size has been the critical point of capital structure decision. The larger companies have more access to funds and less chances of default that’s why they enjoy more borrowings as compare to smaller firms.
Some of the chief factors affecting the choice of the capital structure are the following:
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.
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.
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.
COST OF EQUITY CAPITAL:
Cost of equity capital (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 shareholders.
Floatation costs are those expenses which are incurred while issuing securities (e.g., equity shares, preference shares, debentures, etc.). These include 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.