CBSE XII Financial Management - Factors affecting capital structure

2. Financial Management
Grade XII
Business Studies

3. Learning Objective
• To analyse the factors affecting capital structure.

5. Capital Structure
➢Capital structure refers to the mix between owners and borrowed
funds. These shall be referred as equity and debt. If it is greater than
one, interest expenses will be high and if it is less than one,
shareholders can be hopeful of getting something in case of
liquidation.
➢It can be calculated as debt-equity ratio
𝒅𝒆𝒃𝒕
𝒆𝒒𝒖𝒊𝒕𝒚
➢It can also be calculated as the proportion of debt out of the total
capital i.e.,
𝒅𝒆𝒃𝒕
𝒅𝒆𝒃𝒕 + 𝒆𝒒𝒖𝒊𝒕𝒚

7. cash flow=the total
amount of money being
transferred into and out
of a business,
especially as affecting
liquidity.

9. Factors affecting the Choice of Capital
Structure
1. Cash Flow Position: Cash flows must not only cover fixed cash
payment obligations but there must be sufficient buffer also.
2. Interest Coverage Ratio (ICR):
𝑬𝑩𝑰𝑻
𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕
If it is higher the company
may fail to pay interest on loans.
3. Debt Service Coverage Ratio: Higher DSCR means high borrowing
capacity.
𝑷𝒓𝒐𝒇𝒊𝒕 𝒂𝒇𝒕𝒆𝒓 𝑻𝒂𝒙 + 𝑫𝒆𝒑𝒓𝒆𝒄𝒊𝒂𝒕𝒊𝒐𝒏 + 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 + 𝑵𝒐𝒏. 𝒄𝒂𝒔𝒉 𝒆𝒙𝒑
𝑷𝒓𝒆𝒇. 𝑫𝒊𝒗 + 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 + 𝑹𝒆𝒑𝒂𝒚𝒎𝒆𝒏𝒕 𝑶𝒃𝒍𝒊𝒈𝒂𝒕𝒊𝒐𝒏

10. ICR

11. DSCR

12. DSCR

13. List of the Most Common Non-Cash Expenses
• There are many types to watch out for, but the most common examples
include:
• Depreciation
• Amortization
• Stock-based compensation
• Unrealized gains
• Unrealized losses
• Deferred income taxes
• Goodwill impairments
• Asset write-downs
• Provisions and contingencies for future losses

14. Factors affecting the Choice of Capital
Structure
4.Return on Investment: If ROI is higher, it can choose to use trading
on equity to increase its EPS, i.e., its ability to use debt is greater.
5. Cost of debt: A firm’s ability to borrow at a lower rate increases its
capacity to employ higher debt.

16. Factors affecting the Choice of Capital
Structure
• 6. Tax Rate: Since interest is tax deductible, a higher tax rate
makes debt relatively cheaper.
• 7. Cost of Equity: If debt increases, cost of equity may go up
sharply and share price may decrease inspite of increased
EPS.

17. Factors affecting the Choice of Capital
Structure
• 8. Floatation Costs: If public issue of shares and debentures
costs more, a loan may be cheaper.
• 9. Risk Consideration: If a firm’s business risk is lower, its
capacity to use debt is higher and vice-versa.
• 10. Flexibility: To maintain flexibility, it must maintain some
borrowing power to take care of unforeseen circumstances.

19. Factors affecting the Choice of Capital
Structure
• 11. Control: A public issue of equity make it vulnerable to takeover.
• 12. Regulatory Framework: The relative ease of SEBI guidelines for
issue of shares and bank norms for loans has a bearing upon the
choice of the source of finance.

20. Factors affecting the Choice of Capital
Structure
• 13. Stock Market Conditions: Shares are better if its bullish whereas
debt is better if its bearish.
• 14. Capital Structure of other Companies: Justification must be
there if the company follows or deviates from debt-equity ratios of
other companies in the same industry.

21. Review
Explain the factors affecting capital structure.

23. Recapitulation
Cash Flow Position, Interest Coverage Ratio (ICR), Debt Service
Coverage Ratio, Return on Investment, Cost of debt, Tax Rate, Cost of
Equity, Floatation Costs, Risk Consideration, Flexibility, Control,
Regulatory Framework, Stock Market Conditions and Capital Structure
of other Companies are the factors affecting capital structure.