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Question
Explain briefly any four factors which affect the choice of capital structure of a company.
Solution
Factors affecting the choice of capital structure of a company:
- Cash flow: Debt should be opted by the company only if it has a strong cash flow position. This is because cash would be required to repay the principal along with the interest rate on the debt.
- Debt-service coverage ratio (DSCR): It depicts the cash payment obligations of a company as against its availability of cash. In case DSCR is high, the company can opt for more debt.
- Equity cost: The cost of equity depicts the financial risk faced by the company. If the financial risk is higher, then the shareholders expect a higher return. This, in turn, implies a rise in the cost of equity. However, if the cost of equity is high, then it would be difficult for the company to opt for more equity
- The condition of the stock market: In situations of good stock market conditions, the company can easily opt for equity capital and vice versa.
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Sakshi Ltd. is a company manufacturing electronic goods. It has a share capital ofRs 120 lakhs. The earning per share in the previous year wasRs 0.5. For diversification, the company requires additional capital ofRs 80 lakhs. The company raised funds by issuing 10% debentures for the same. During the current year the company earned profit ofRs 16 lakhs on capital employed. It paid tax @ 40%.
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Mr. A. Bose is running a successful business. Mr. Bose is the owner of R. K. Cement Ltd. Mr. Bose decided to expand his business by acquiring a Steel Factory. This required an investment of Rs. 60 crores. To seek advice in this matter, he called his financial advisor Mr. T. Ghosh who advised him about the judicious mix of equity (40%) and Debt (60%). Employ more of cheaper debt may enhance the EPS. Mr. Ghosh also suggested him to take loan from a financial institution as the cost of raising funds from financial institutions is low. Though this will increase the financial risk but will also raise the return to equity shareholders. He also apprised him that issue of debt will not dilute the control of equity shareholders. At the same time, the interest on loan is a tax deductible expense for computation of tax liability. After due deliberations with Mr. Ghosh, Mr. Bose decided to raise funds from a financial institution.
Identify the concept of Financial Management as advised by Mr. Ghosh in the above situation.
ICR = ______
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Show the working.
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