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.
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),
This refers to the risk of inability to pay fixed financial payments (e.g., payment of interest, preference dividend, return of the debt capital, etc.) as promised by the company.
If the operating risk in business is less, the financial risk can be faced i.e., more debt capital can be utilized. If the operating risk is high, the financial risk should be avoided.
Capital structure should be fairly flexible. Flexibility means that 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.
If at any given time company has more capital than necessary then both the above-mentioned capitals can be repaid. On the other hand, repayment of equity share capital is not possible by the company during its lifetime. Thus, from the viewpoint of flexibility, issuing debt capital and preference share capital is the best.
At the time of preparing 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 company’s shareholders will be increased and it directly affects the control of existing shareholders. In other words, now the number of owners (shareholders) controlling the company are increased. This situation will not be acceptable to the existing shareholders. Contrariwise, when funds are raised through debt capital, there is no effect on the control of the company because the debenture holders have no control over the affairs of the company. Thus, for those who support this principle debt capital is the best.