Question

Elucidate any four factors affecting the capital structure of a joint stock company.

Answer 1

Factors affecting capital structure:

1. Business risk: Business risk refers to the inherent risk associated with the specific operations of the company. Companies with higher business risks tend to have more volatile earnings. As a result, these companies might prefer equity financing over debt to avoid the pressure of fixed-interest payments, which can be difficult to manage during periods of low earnings.
2. Industry Averages: The capital structure of companies within the same industry often follows certain norms or averages. This is because companies within the same industry face similar risks and competitive pressures. By aligning their capital structure with industry averages, companies can benchmark their financial strategies and ensure they remain competitive and attractive to investors. 
3. Company's Tax Status: The tax implications of financing decisions play a crucial role in determining capital structure. Interest payments on debt are tax-deductible, which can provide a tax shield and reduce the overall tax burden of the company. Companies with higher tax rates may prefer debt financing to take advantage of these tax benefits.
4. Expected Cash Flows: The predictability and stability of a company’s expected cash flows influence its ability to service debt. Companies with stable and predictable cash flows are more likely to take on higher levels of debt, as they can reliably meet interest and principal payments. Conversely, companies with uncertain or volatile cash flows might prefer equity financing to avoid the risk of default.