question_answer 27)

What are the factors which will affect the capital structure of this company?

Answer:

Capital structure refers to the proportion in which debt and equity funds are used for financing the operations of a business. A capital structure is said to be optimum when the proportion of debt and equity is such that it results in an increase in the value of shares. The factors that will affected the capital structure of this company are (i) Equity Funds The composition of equity funds in the capital structure will be governed by the following factors (a) The requirement of funds of 'S' Limited is for long term. Half equity funds will be more appropriate. (b) There are no financial risks attached to this form of funding. (c) If the stock market is bullish, the company can easily raise funds through issue of equity shares. (d) If the company already has raised reasonable amount of debt funds, each subsequent borrowing will come at a higher interest rate and will increase the fixed charges. (i) Debt Funds The usage and the ratio of debt funds in the capital structure will be governed by factors like (a) The availability of cash flow with the company to meet its fixed financial charges. The purpose is to reduce the financial risk associated with such payments which can further be checked by using 'debt' service coverage ratio. (b) It will provide the benefit of trading on equity and hence will increase the earning per share of equity shareholders However, 'return on investment' ratio will be the guiding principle behind it. The company should opt for trading on equity only when return on investment is more than the fix charges. (c) Interest on debt funds is a deductible expense and therefore, will reduce the tax liability. (d) It does not result in dilution of management control.