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Question
State any three factors determining the choice of an appropriate capital structure of a company.
Solution
Factors Affecting the Choice of Capital Structure:
- Cash flow position: Before choosing the capital structure of the company, it is important to take into account the magnitude of the anticipated cash flows. Debt can be used if there is enough cash flow, but it must fulfill set payment obligations. The business must make specific cash payments for things like (i) routine business operations, (ii) investments in fixed assets, (iii) debt servicing obligations, and (iv) maintaining a suitable buffer.
- Interest coverage ratio:
- The interest coverage ratio, computed as EBIT/Interest, measures how often a company's earnings before interest and taxes (EBIT) cover its interest commitment.
- The greater the interest coverage ratio, the lesser the danger that the company would fail to satisfy its interest payment commitments.
- Debt Service Coverage Ratio: The cash earnings created by activities are compared to the amount of money required to pay off the debt and the capital for the preference shares. The following is the formula:
Debt. Service coverage ratio = (Profit after tax + Depreciation + Interest + Non Cash)/(Expenses Preference Dividend + Interest + Repayment Obligation) - Return On Investment: If the company's return on investment is better, it can opt to enhance its EPS through trading on equity, implying that its flexibility to employ debt is stronger.
- Cost Of Equity:
- When a corporation employs more debt, the financial risk that equity holders face increases, as does their desired rate of return.
- If debt is employed beyond a certain threshold, the cost of equity may rise quickly, and the share price may fall despite rising EPS.
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Viyo Ltd.' is a company manufacturing textiles. It has a share capital of Rs 60 lakhs. The earnings per share in the previous year was Rs 0.50. For diversification, the company requires additional capital of Rs 40 lakhs. The company raised funds by issuing 10% debentures for the same. During the current year the company earned profit of Rs 8 lakhs on capital employed. It paid tax @ 40%.
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