Factors Affecting Capital Structure and Explanations:

Capital structure refers to the way a company finances its operations and growth by using different sources of funds. There are various factors that affect a company's capital structure, which are as follows:

1. Business Risk: The level of business risk faced by a company influences its capital structure decisions. Companies with higher business risk tend to use more equity financing.

2. Financial Risk: The level of financial risk faced by a company also affects its capital structure decisions. Companies with higher financial risk tend to use more debt financing.

3. Profitability: Profitable companies tend to use more debt financing as they can easily service their debt obligations.

4. Taxation: The tax laws prevailing in a country affect a company's capital structure decisions. Companies in countries with high tax rates tend to use more debt financing as interest payments on debt are tax-deductible.

5. Growth Opportunities: Companies with high growth opportunities tend to use more equity financing as they want to retain ownership and control.

6. Size: Larger companies have easier access to debt financing as they are more creditworthy than smaller companies.

7. Collateral: Companies with adequate collateral can easily obtain debt financing at lower interest rates.

8. Interest Rates: The prevailing interest rates in the economy affect a company's cost of debt financing.

9. Market Conditions: The state of the capital markets affects a company's ability to raise funds through equity financing.

10. Company's Credit Rating: Companies with higher credit ratings can easily access debt financing at lower interest rates.

11. Industry Characteristics: Companies operating in industries with stable cash flows tend to use more debt financing.

12. Management Attitudes: The attitudes of the management towards risk also influence the company's capital structure decisions.

13. Legal Considerations: The legal framework of a country affects a company's ability to raise funds through equity or debt financing.

14. Competitive Environment: The competitive environment in which a company operates affects its ability to raise funds through equity or debt financing.

Conclusion:

The above factors must be considered while deciding the capital structure of a company. The optimal capital structure of a company is the one that maximizes its value by balancing the benefits and costs of using debt and equity financing.

Factor affecting capital structure
(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 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. 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. Better ratio means the better capacity of the company for debt payment. Consequently, more debt can be utilised in the capital structure.

(4) Return on Investment-ROI: The greater return on investment of a company increases its capacity to utilise 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 utilised 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.

For example, suppose a company takes a loan of 0ppp 100 and the rate of interest on this debt is 10% and the rate of tax is 30%. By deducting 10/- from the EBIT a saving of in tax will take place (If 10 on account of interest are not deducted, a tax of @ 30% shall have to be paid).

(7) Cost of Equity Capital: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 utilised 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.

Therefore, the use of the debt capital can be made only to a limited level. If even after this level the debt capital is used further, the cost of equity capital starts increasing rapidly. It adversely affects the market value of the shares. This is not a good situation. Efforts should be made to avoid it.

(8) Floatation Costs: 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.

(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, return of the debt capital, etc.) as promised by the company.

The total risk of business depends on both these types of risks. If the operating risk in business is less, the financial risk can be faced which means that more debt capital can be utilised. On the contrary, if the operating risk is high, the financial risk likely occurring after the greater use of debt capital should be avoided.

(10) Flexibility:

According to this principle, capital structure should be fairly flexible. Flexibility means that, if need be, 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 as 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 to issue debt capital and preference share capital is the best.

(11) Control:According to this factor, 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 increase and it directly affects the control of existing shareholders. In other words, now the number of owners (shareholders) controlling the company increases.

This situation will not be acceptable to the existing shareholders. On the contrary, 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.

(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.

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.

(13) Stock Market Conditions: Stock market conditions refer to upward or downward trends in 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 high risk.

On the contrary, when conditions in the capital market are cheerful, they treat investment in the share capital as the best choice to reap profits. Companies should, therefore, make selection of capital sources keeping in view the conditions prevailing in the capital market.

(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.

Because of this fact, there are different debt- equity ratios prevalent in different industries. Hence, at the time of raising funds a company must take into consideration debt-equity ratio prevalent in the related industry.