Determinants of the optimal capital structure
A capital structure is said to be optimal when the proportion of debt and equity is such that it increases the value of equity shares. In this post, we will learn the main determinants of optimal capital structure.
Factors affecting the choice of capital structure
Factors or determinants of the optimal capital structure are:
1. Cash Flow Position
While deciding the capital structure, the future cash flow position should be kept in mind. If the company wants to raise debt, it must ensure that enough cash flows are expected to meet debt obligations. Debt obligations include interest payment and repayment of the principal amount.
In the case of cash-shortage is expected, then companies should use more equity.
2. Interest Coverage Ratio
Interest Coverage ratio refers to the number of times earnings before interest and taxes (EBIT) of a company covers interest obligation.
ICR = EBIT/ INTEREST
Higher ICR means companies can have more debt as there is less risk of meeting the interest payment obligation.
In case of a lower ratio, companies should use less debt.
3. Debt Service Coverage Ratio
It takes care of the deficiencies referred to in the interest coverage ratio. The cash profit generated by the operations is compared with the total cash required for the service of the debt and the preference share capital.
A higher debt service coverage ratio indicates a better ability to meet cash commitments and consequently the companies potential to increase the debt component in its capital structure.
4.Return on Investment
If the rate of investment increases, it can choose to use trading on equity to increase its earnings per share, that is, its ability to use debt is greater.
For example, return on investment is 6.67% whereas interest on debt is 10%, in this case, the use of debt reduces the Earnings per share.
5. Cost of debt
A firm’s ability to borrow at a lower rate increases its capacity to employ higher debt. Therefore, more debt can be used if the debt can be raised at a lower rate.
6. Tax rate
Since interest is a deductible expense, the cost of debt is affected by the tax rate. An increase in tax rate makes debt relatively cheaper and increases its attraction as compared to equity.
7. Cost of equity
The use of higher debt increases the cost of equity as the financial risk faced by the equity shareholder increases, hence debt should be used up to a level.
If an existing shareholder wants complete control then they should prefer debt, loans of small amount, etc. If they don’t mind sharing the control then they may go for equity shares also.
9. Floatation Cost
Floatation cost is the cost involved in the issue of shares or debenture. These costs include the cost of advertisement, underwriting statutory fees, etc.
Issue of shares, debentures requires more formalities as well as more floatation cost. Whereas, there is less cost involved in raising capital by loans or advances.
10. Risk consideration
Financial risk refers to a position when a company is unable to meet its fixed financial charges such as interest, preference dividend, payment to creditors, etc. If a firm’s business risk is low then it can raise more capital by issue of debt otherwise, it should depend on equity.
If a firm uses its debt potential to the full, it loses the flexibility to issue further debt. To maintain flexibility, it must maintain some borrowing power to take care of unforeseen circumstances.
12. Regulatory framework
Issue of shares and debentures have to be done within the SEBI guidelines and for taking loans. Companies have to follow the regulations of monetary policies.
13. Stock market conditions
There are 2 main conditions of the market, that is, Boom condition and Recession or Depression condition. These conditions affect the capital structure especially when the company is planning to raise additional capital.
During the depression, investors prefer debt whereas, during the booming equity is preferred.
14. Capital structure of other companies
A useful guideline in capital structure planning is the debt-equity ratios of other companies in the same industry. There are usually the same industry norms that may help. For example, if the business risk of a firm is higher, it cannot afford the same financial risk.
So many factors, how can we memorize them?
“Use the code 5C-3R-2F-1D-SIT“
5 C includes; Cash flow position, Cost of Debt, Cost of Equity, Control and Capital structure of other companies.
3R includes; Return on investment, Risk consideration and Regulatory framework
2F includes; Floatation cost and Flexibility
1D includes; Debt service coverage ratio
SIT includes; Stock market conditions, Interest coverage ratio and Tax rate
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