Overview , market understanding, deep drive

1. FM INTERNAL
ASSIGNMENT MMM
FIRST YEAR 2014-15
MMM 14-M-511
TANMAY RAJPURKAR

2. Q1. Explain the concepts of cost of capital and weighted average cost of capital. What are the
assumptions on which the theory of cost of capital is based
Ans. Cost of Capital is the rate that must be earned in order to satisfy the required rate of return of
the firm's investors. It can also be defined as the rate of return on investments at which the price of
a firm's equity share will remain unchanged. Each type of capital used by the firm (debt,
preference shares and equity) should be incorporated into the cost of capital, with the relative
importance of a particular source being based on the percentage of the financing provided by
each source of capital. Using of the cost a single source of capital, as the hurdle rate is tempting to
management, particularly when an investment is financed entirely by debt. However, doing so is a
mistake in logic and can cause problems.
Factors determining the cost of capital:
There are several factors that impact the cost of capital of any company. This would mean that the
cost of capital of any two companies would not be equal. Rightly so as these two companies would
not carry the same risk.
A. General economic conditions: These include the demand for and supply of capital within the
economy, and the level of expected inflation. These are reflected in the risk less rate of return
and are common to most of the companies.
B. Market conditions: The security may not be readily marketable when the investor wants to sell;
or even if a continuous demand for the security does exist, the price may vary significantly. This
is company specific.
C. A firm's operating and financing decisions: Risk also results from the decisions made within the
company. This risk is generally divided into two classes:
1. Business risk is the variability in returns on assets and is affected by the company's
investment decisions.
2. Financial risk is the increased variability in returns to the common stockholders as a result of
using debt and preferred stock
D. Amount of financing required: The last factor determining the company's cost of funds is the
amount of financing required, where the cost of capital increases as the financing requirements
become larger. This increase may be attributable to one of the two factors:
1. As increasingly larger public issues are increasingly floated in the market, additional
flotation costs (costs of issuing the security) and underpricing will affect the percentage cost
of the funds to the firm.
2. As management approaches the market for large amounts of capital relative to the firm's
size, the investors' required rate of return may rise. Suppliers of capital become hesitant to
grant relatively large amounts of funds without evidence of management's capability to
absorb this capital into the business.
E. Market conditions: The security may not be readily marketable when the investor wants to sell;
or even if a continuous demand for the security does exist, the price may vary significantly. This
is company specific.
F. A firm's operating and financing decisions: Risk also results from the decisions made within the
company. This risk is generally divided into two classes:
Assumptions of the cost of capital model
A. Constant business risk: We assume that any investment being considered will not significantly
change the firm's business risk. Therefore the overall cost of capital would not change with the
changing nature of investments in different markets.

3. B. Constant financial risk: Management is assumed to use the same financial mix as it used in the
past with the same combination of debt and equity.
C. Constant dividend policy:
1. For ease of computation, it is generally assumed that the firm's dividends are increasing at
a constant annual growth rate. Also, this growth is assumed to be a function of the firm's
earning capabilities and not merely the result of paying out a larger percentage of the
company's earnings.
2. We also implicitly assume that the dividend payout ratio (dividend/net income) is constant.
Weighted Average cost of Capital
A company has different sources of finance, namely common stock, retained earnings, preferred
stock and debt. Weighted average cost of capital (WACC) is the average after tax cost of all the
sources. It is calculated by multiplying the cost of each source of finance by the relevant weight and
summing the products up.
Formula
For a company which has two sources of finance, namely equity and debt, WACC is calculated
using the following formula:
WACC = Weight of Equity x Cost of Equity + Weight of Debt x Cost of Debt
Cost of equity is calculated using different models for example dividend growth model and capital
asset pricing model. Cost of debt is based on the yield to maturity of the relevant instruments. If no
yield to maturity can be calculated we can base the estimate on the instrument's current yield, etc.
The weights are based on the target market values of the relevant components. But if no market
values are available we base the weights on book values.
Example
Company ABC has a 1 million shares of common stock currently trading at Rs. 30 per share. Current
risk free rate is 4%, market risk premium is 8% and the company has a beta of 1.2.
It also has 50,000 bonds with of Rs. 1,000 par paying 10% coupon annually maturing in 20 years
currently trading at Rs. 950.
The tax rate is 30%. Calculate the weighted average cost of capital.
Solution:
First we need to calculate the weights of debt and equity.
Market Value of Equity = 1,000,000 × Rs. 30 = Rs. 30,000,000
Market Value of Debt = 50,000 × Rs. 950 = Rs. 47,500,000
Total Market Value of Debt and Equity = Rs. 77,500,000
Weight of Equity = Rs. 30,000,000 / Rs. 77,500,000 = 38.71%
Weight of Debt = Rs. 47,500,000 / Rs. 77,500,000 = 61.29%
Weight of Debt can be calculated as 100% minus cost of equity = 100% − 38.71% = 61.29%
Second step in our solution is to calculate the cost of equity. With the given data we can use capital
asset pricing model (CAPM) to calculate cost of equity as follows:
Cost of Equity = Risk Free Eate + Beta × Market Risk Premium = 4% + 1.2 × 8% = 13.6%
We also, need to find the cost of debt. Cost of debt is equal to the yield to maturity of the bonds.
With the given data, we can find that yield to maturity is 10.61%.

4. After tax cost of debt is hence 10.61% × ( 1 − 30% ) = 7.427%
And finally, WACC = 38.71% × 13.6% + 61.29% × 7.427% = 9.8166%
Uses of WACC
Weighted average cost of capital is used in discounting cash flows for calculation of NPV and other
valuations for investment analysis.
WACC represents the average risk faced by the organization. It would require an upward
adjustment if it has to be used to calculate NPV of project which are more risk than the company's
average projects and a downward adjustment in case of less risky projects.

5. Q2. Discuss the different factors affecting dividend policy of a company
Ans. A number of considerations affect the dividend policy of company. The major factors are:
1. Stability of Earnings. The nature of business has an important bearing on the dividend policy.
Industrial units having stability of earnings may formulate a more consistent dividend policy than
those having an uneven flow of incomes because they can predict easily their savings and
earnings. Usually, enterprises dealing in necessities suffer less from oscillating earnings than those
dealing in luxuries or fancy goods.
2. Age of corporation. Age of the corporation counts much in deciding the dividend policy. A
newly established company may require much of its earnings for expansion and plant
improvement and may adopt a rigid dividend policy while, on the other hand, an older company
can formulate a clear cut and more consistent policy regarding dividend.
3. Liquidity of Funds. Availability of cash and sound financial position is also an important factor
in dividend decisions. A dividend represents a cash outflow, the greater the funds and the liquidity
of the firm the better the ability to pay dividend. The liquidity of a firm depends very much on the
investment and financial decisions of the firm which in turn determines the rate of expansion and
the manner of financing. If cash position is weak, stock dividend will be distributed and if cash
position is good, company can distribute the cash dividend.
4. Extent of share Distribution. Nature of ownership also affects the dividend decisions. A closely
held company is likely to get the assent of the shareholders for the suspension of dividend or for
following a conservative dividend policy. On the other hand, a company having a good number of
shareholders widely distributed and forming low or medium income group, would face a great
difficulty in securing such assent because they will emphasise to distribute higher dividend.
5. Needs for Additional Capital. Companies retain a part of their profits for strengthening their
financial position. The income may be conserved for meeting the increased requirements of
working capital or of future expansion. Small companies usually find difficulties in raising finance
for their needs of increased working capital for expansion programmes. They having no other
alternative, use their ploughed back profits. Thus, such Companies distribute dividend at low rates
and retain a big part of profits.
6. Trade Cycles. Business cycles also exercise influence upon dividend Policy. Dividend policy is
adjusted according to the business oscillations. During the boom, prudent management creates
food reserves for contingencies which follow the inflationary period. Higher rates of dividend can
be used as a tool for marketing the securities in an otherwise depressed market. The financial
solvency can be proved and maintained by the companies in dull years if the adequate reserves
have been built up.
7. Government Policies. The earnings capacity of the enterprise is widely affected by the change
in fiscal, industrial, labour, control and other government policies. Sometimes government restricts
the distribution of dividend beyond a certain percentage in a particular industry or in all spheres
of business activity as was done in emergency. The dividend policy has to be modified or
formulated accordingly in those enterprises.
8. Taxation Policy. High taxation reduces the earnings of he companies and consequently the rate
of dividend is lowered down. Sometimes government levies dividend-tax of distribution of
dividend beyond a certain limit. It also affects the capital formation. N India, dividends beyond
10 % of paid-up capital are subject to dividend tax at 7.5 %.

6. 9. Legal Requirements. In deciding on the dividend, the directors take the legal requirements too
into consideration. In order to protect the interests of creditors an outsiders, the companies Act
1956 prescribes certain guidelines in respect of the distribution and payment of dividend.
Moreover, a company is required to provide for depreciation on its fixed and tangible assets
before declaring dividend on shares. It proposes that Dividend should not be distributed out of
capita, in any case. Likewise, contractual obligation should also be fulfilled, for example, payment
of dividend on preference shares in priority over ordinary dividend.
10. Past dividend Rates. While formulating the Dividend Policy, the directors must keep in mind
the dividend paid in past years. The current rate should be around the average past rat. If it has
been abnormally increased the shares will be subjected to speculation. In a new concern, the
company should consider the dividend policy of the rival organisation.
11. Ability to Borrow. Well established and large firms have better access to the capital market
than the new Companies and may borrow funds from the external sources if there arises any need.
Such Companies may have a better dividend pay-out ratio. Whereas smaller firms have to
depend on their internal sources and therefore they will have to built up good reserves by
reducing the dividend pay out ratio for meeting any obligation requiring heavy funds.
12. Policy of Control. Policy of control is another determining factor is so far as dividends are
concerned. If the directors want to have control on company, they would not like to add new
shareholders and therefore, declare a dividend at low rate. Because by adding new shareholders
they fear dilution of control and diversion of policies and programmes of the existing
management. So they prefer to meet the needs through retained earing. If the directors do not
bother about the control of affairs they will follow a liberal dividend policy. Thus control is an
influencing factor in framing the dividend policy.
13. Repayments of Loan. A company having loan indebtedness are vowed to a high rate of
retention earnings, unless one other arrangements are made for the redemption of debt on
maturity. It will naturally lower down the rate of dividend. Sometimes, the lenders (mostly
institutional lenders) put restrictions on the dividend distribution still such time their loan is
outstanding. Formal loan contracts generally provide a certain standard of liquidity and solvency
to be maintained. Management is bound to hour such restrictions and to limit the rate of dividend
payout.
14. Time for Payment of Dividend. When should the dividend be paid is another consideration.
Payment of dividend means outflow of cash. It is, therefore, desirable to distribute dividend at a
time when is least needed by the company because there are peak times as well as lean periods
of expenditure. Wise management should plan the payment of dividend in such a manner that
there is no cash outflow at a time when the undertaking is already in need of urgent finances.
15. Regularity and stability in Dividend Payment. Dividends should be paid regularly because
each investor is interested in the regular payment of dividend. The management should, inspite of
regular payment of dividend, consider that the rate of dividend should be all the most constant.
For this purpose sometimes companies maintain dividend equalization Fund.

7. Q3. Discuss various sources of long term finance in brief
Ans. The sources of long-term finance refer to the institutions or agencies from, or through which finance
for a long period can be procured. In case of sole proprietary concerns and partnership firms,
long-term funds are generally provided by the owners themselves and by the retained profits. But,
in case of companies whose financial requirement is rather large, the following are the sources
from, or through which long-term funds are raised.
A) CAPITAL MARKET
B) SPECIAL FINANCIAL INSTITUTIONS
C) MUTUAL FUNDS
D) LEASING COMPANIES
E) FOREIGN SOURCES
F) RETAINED EARNINGS
A) CAPITAL MARKET
Capital market refers to the organisation and the mechanism through which the companies, other
institutions and the government raise long-term funds. So it constitutes all long-term borrowings
from banks and financial institutions, borrowings from foreign markets and rising of capitals by
issuing various securities such as shares debentures, bonds, etc. For trading of securities there are
two different segments in capital market. One is primary market and the other is secondary
market. The primary market deals with new/fresh issue of securities and is, therefore, known as
new issue market. The secondary market on the other hand, provides a place for purchase and
sale of existing securities and is known as stock market or stock exchange. The new issue market
primarily consists of the arrangements, which facilitates the procurement of long-term finance by
the companies in the form of shares, debentures and bonds. The companies usually issue those
securities at the initial stages of their formation and so also later on for expansion and/or
modernization of their activities.
However, the selling of securities is not an easy task, as the companies have to fulfill various legal
requirements and decide upon the appropriate timing and the method of issue. Hence, they seek
assistance of various intermediaries such as merchant bankers, underwriters, and stock brokers etc.
to look after all these aspects. All these intermediaries form an integral part of the primary
market.
The secondary market (stock exchange) is an association or organisation or a body of individuals
established for the purpose of assisting, regulating and controlling the business of buying, selling
and dealing in securities. It may be noted that it is called a secondary market because only the
securities already issued can be traded on the floor of the stock exchange. This market is open
only to its members, most of whom are brokers acting as agents of the buyers and sellers of
securities. The main functions of this market lie in providing liquidity (ready encashment) to
securities and safety in dealings. It is because of the availability of such facilities that people are
ready to invest in securities.
B) SPECIAL FINANCIAL INSTITUTIONS
A number of special financial institutions have been set up by the central and state governments to
provide long-term finance to the business organisations. They also offer support services in
launching of the new enterprises and so also for expansion and modernisation of existing

8. enterprises. Some of the important ones are Industrial Finance Corporation of India (IFCI), Industrial
Investment Bank of India (IIBI), Industrial Credit and Investment Corporation of India (ICICI),
Industrial Development Bank of India (IDBI), Infrastructure Development Finance Company Ltd.
(IDFC), Small Industries Development Bank of India (SIDBI), State Industrial Development
Corporations (SIDCs), and State Financial Corporations (SFCs), etc. Since these institutions provide
developmental finance, they are also known as Development Banks or Development Financial
Institutions (DFI). Besides these development banks there are a few other financial institutions such
as life Insurance Corporation of India (LIC), General Insurance Corporation of India (GIC) and Unit
Trust of India (UTI) which provide long-term finance to companies and subscribe to their share and
debentures. The main functions of these institutions are:
(i) To grant loans for a longer period to industrial establishment
(ii) To help the establishment of business units that require large amount of funds and have long
gestation period
(iii) To provide support for the speedy development of the economy in general and backward
regions in particular
(iv) To offer specialized services operating in the areas of promotion, project assistance, technical
assistance services and training and development of entrepreneurs
(v) To provide technical and professional management services and help in identification,
evaluation and execution of new projects.
C) MUTUAL FUNDS
Mutual fund refers to a fund established in the form of a trust by a sponsor to raise money through
one or more schemes for investing in securities. It is a special type of investment institution, which
acts as an investment intermediary that collects or pools the savings of a large number of investors
and invests them in a fairly large and well diversified portfolio of sound investments. This minimizes
their risk and ensures good returns to the investors. Thus, they act as an investment agency for
small investors and a good source for long-term finance for the business.
Features of Mutual Funds: The essential features of mutual funds are as follows:
1. It is a trust into which a number of investors invest their money in the form of units to form a
large pool of funds.
2. The amount is invested in securities by the managers of the fund.
3. The amount is invested in different securities of reputed companies to ensure definite and
regular income. Thus, it helps in minimizing the risk.
4. The mutual fund schemes often have the advantages of high return, easy liquidity, safety and
tax benefits to the investors.
5. The net income received on the investments of the fund is distributed over the units held.
6. The managers of the fund are obliged to redeem the units on demand or on the expiry of a
specified period.
Types Of Mutual Funds: Keeping in view the investment objectives of the investors the mutual
funds usually have a large variety of schemes such as equity fund, debt fund, balanced fund,
growth fund, income fund, liquid fund, tax saver fund, index fund and so on. These schemes are
broadly classified into two categories as follows:
(a) Open Ended Funds: These funds have no fixed corpus and period. Such fund continuously offer
units for sale and is ready to buy back the units surrendered. In other words, investors are free to
buy from, or sell to, the trust any number of units at any point of time at prices which are linked to
the net asset value (NAV) of the units.

9. (b) Close Ended Funds: In case of these funds, subscriptions from the investors are collected during
a specified time period and have a fixed corpus. Not only that, the investors cannot redeem their
units till the specified maturity date. However, to provide liquidity, these are listed on the stock
exchange and the investors can purchase and sell through the brokers at the market price without
any difficulty.
D) LEASING COMPANIES
This method has become quite common among the manufacturing companies. Leasing facility is
usually provided through the mediation of leasing companies who buy the required plant and
machinery from its manufacturer and lease it to the company that needs it for a specified period
on payment of an annual rent. For this purpose a proper lease agreement is made between the
lessor (leasing company) and lessee (the company hiring the asset). Such agreement usually
provides for the purchase of the machinery by the lessee at the end of the lease period at a
mutually agreed and specified price. It may be noted that the ownership remains with the leasing
company during the lease period. Sometimes, a company, to meet its financial requirements, may
sell its own existing fixed asset (machinery or building) to a leasing company at the current market
price on the condition that the leasing company shall lease the asset back to selling company for a
specified period. Such an arrangement is known as ‘Sell and Lease Back’. The company in such
arrangement gets the funds without having to part with the possession of the asset involved which it
continues to use on payment of annual rent for the lease. It may be noted that in any type of
leasing agreement, the lease rent includes an element of interest besides the expenses and profits
of the leasing company. In fact, the leasing company must earn a reasonable return on its
investment in lease asset. The leasing business in India started, in seventies when the first leasing
company of India was promoted by Chitambaram Group in 1973 in Chennai. The Twentieth
Century Finance Company and four other finance companies joined the fray during eighties. Now
their number is very large and leasing has emerged as an important source. It is very helpful for
the small and medium sized undertakings, which have limited financial resources.
E) FOREIGN SOURCES
Foreign Sources also play an important part in meeting the long-term financial needs of the
business in India. These usually take the form of (1) external borrowings; (2) foreign investments
and; (3) deposits from NRIs.
(1) External Borrowings: These include loans obtained at concessional rates of interest with long
maturity period and commercial borrowings. The major sources of concessional loans have
been the International Monetary Fund (IMF), Aid India Consortium (AIC), Asian Development
Bank (ADB), World Bank (International Bank for Reconstruction and Development) and
International Financial Corporation. The World Bank grants loans for specific industrial
projects of high priority and given either directly to an industrial concern or through a
government agency. The International Finance Corporation, an affiliate of the World Bank,
grants loans to industrial units for a period of 8 to 10 years. Such loans do not require
government guarantee. As for the external commercial borrowings, their major sources has
been the export credit agencies like US Exim Bank, the Japanese Exim Bank, Export Credit
and Guarantee Corporation of U.K. and other government and multilateral agencies. The
external commercial borrowings are permitted by the government as an important source of
finance for Indian firms for the expansion investments.
(2) Foreign Investments: The foreign investments in our country are generally done in the form of
foreign direct investment (FDI) or through foreign collaborations. The foreign direct investment
usually refers to the subscription by the foreigners to shares and debentures of the Indian

10. Companies. This is also known as portfolio investment and covers their subscription to ADRs,
GDRs and FCCBs (Foreign Currency Convertible Bonds). Alternatively, some companies are
formed with the specified purpose of operating in India or the multinationals can set up their
subsidiary or branch in India. As for the foreign collaborations, these can be of financial
collaborations involving foreign companies’ participation in equity capital of an existing or
new undertaking. The technical collaborations are by way of supply of technical knowledge,
patents and machineries. To start with, the technical collaborations had been the more popular
form in the past. But during the post liberalization phase, shift from technical collaborations to
financial collaborations is noticed in our country. It may be noted that the government has
been very successful in attracting more foreign investment in the post liberalisation era. It is
because the Government of India now permits automatic approval of foreign investment upto
51% equity in 34 industries and a special board (Foreign Investment Promotion Board) has
been set up to process cases not covered by automatic approvals. The main advantage of
foreign investment is that generally the foreign investor also brings with him the technical
expertise and the modern machinery. The disadvantage, however, is that a large part of
profits are transferred to the foreign investors.
(3) Non-resident Indians (NRIs): You are aware that the persons of Indian origin (PIO) living
abroad commonly known as Non-Resident Indians (NRIs) constitute an important source of
long-term finance for industries in India. The most common form of their contribution is in the
form of deposits under Foreign Currency Non-Resident Account (FCNRA) and Non-Resident
(External) Rupee Account (NRERA). It is worth noting that the share of NRI deposits in the total
foreign capital flows (net) was 26.7% during the year 2001-02. However, like external
borrowing, NRI deposits are high cost source of external finance and are fair weather friends.
Hence, too much dependence on NRI deposits is not a right policy. It may be noted that they
are also permitted to subscribe to the shares and debentures of the companies in India, and
have the option of selling them and take back the amount. This constitutes an integral part of
foreign direct investment.
F) RETAINED EARNINGS
Retained earnings refer to the undistributed profits of companies which is usually kept in the form
of general reserve. Primarily, it is a hedge against low profits in future and is used for the issue of
bonus shares by the company. But, in effect, it acts as an import source of long-term finance for the
companies with Zero cost of capital. The retained profits can be used for expansion and
modernization programmes by the companies. The amount of retained earnings is determined by
the quantum of profits, the dividend payout policy followed by the management, the legal
provisions for dividend payment, and the rate of corporate taxes etc.
It is an internal source, which does not involve any cost of floatation and the uncertainties of
external financing. In fact, it is regarded as the most dependable source of long-term finance. It
also strengthens the firm’s equity base, which enables to borrow at better terms and conditions.
The main drawbacks of this source are (a) it is fully dependent on the accuracy of profits; and (b)
possibility of reckless use of funds by the management.

11. Q4. What are the factors considered in designing capital structure? How the optimum capital structure
is arrived at?
Ans. CAPITAL STRUCTURE
Capital Structure is referred to as the ratio of different kinds of securities raised by a firm as
long-term finance. The capital structure involves two decisions:
a. Types of securities to be issued are equity shares, preference shares and long term
borrowings (Debentures).
b. Relative ratio of securities can be determined by process of capital gearing. On this basis,
the companies are divided into two-
i. Highly geared companies - Those companies whose proportion of equity
capitalization is small.
ii. Low geared companies - Those companies whose equity capital dominates total
capitalization.
Assumptions / Example: There are two companies A and B. Total capitalization amounts to be Rs
2,00,000 in each case. The ratio of equity capital to total capitalization in company A is Rs 50,000,
while in company B, ratio of equity capital is Rs 150,000 to total capitalization, i.e, in Company A,
proportion is 25% and in company B, proportion is 75%. In such cases, company A is considered to
be a highly geared company and company B is low geared company.
While designing an optimum capital structure the following factors are to be con-sidered
carefully:
1. Profitability:
An optimum capital structure must provide sufficient profit. So the profitability aspect is to be
verified. Hence an EBIT-EPS analysis may be performed which will help the firm know the EPS
under various financial alternatives at different levels of EBIT. Apart from EBIT-EPS analysis
the company may calculate the coverage ratio to know its ability to pay interest.
2. Liquidity:
Along with profitability the optimum capital structure must allow a firm to pay the fixed
financial charges. Hence the liquidly aspect of the capital structure is also to be tested. This
can be done through cash flow analysis. This will reduce the risk of insolvency. The firm will
separately know its operating cash flow, non-operating cash flow as well as financial cash
flow. In addition to the cash flow analysis various liquidity ratios may be tested to judge the
liquidity position of the capital structure.
3. Control:
Another important aspect in designing optimum capital structure is to ensure control. The
supplies of debt have no role to play in managing the firm; but equity holders have right to
select management of the firm. So more debt means less amount of control by the supplier of
funds. Hence the management will decide the extent of control to be retained by them while
designing optimum capital structure.
4. Industry Average:
The firm should be compared with the other firms in the industry in terms of profitability and
leverage ratios. The amount of financial risk borne by other companies must be con-sidered
while designing the capital structure. Industry average provides a benchmark in this respect.
However it is not necessary that the firm should follow the industry average and keep its
leverage ratio at par with other companies; however, the comparison will help the firm to act
as a check valve in taking risk.

12. 5. Nature of Industry:
The management must take into consideration the nature of the industry the firm belongs to
while designing the optimum capital structure. If the firm belongs to an industry where sales
fluctuate frequently then the operating leverage must be conservative. In case of firms
belonging to an industry manufacturing durable goods, the financial leverage should be
conservative and the firm can depend less on debt. On the other hand, firms producing less
expensive products and having lesser fluctuation in demand may take an aggressive debt
policy.
6. Manoeuvrability in Funds:
There should be wide flexibility in sourcing the funds so that firm can adjust its long-term
sources of funds if necessary. This will help firm to combat any unforeseen situations that may
arise in the economic environment. Moreover, flexibility allows firms to avail the best
opportunity that may arise in future. Management must keep provision not only for obtaining
funds but also for refunding them.
7. Timing of Raising Funds:
Timing is yet another important factor that needs to be considered while raising funds. Right
timing may allow the firm to obtain funds at least cost. Here the management needs to keep a
constant vigil on the stock market, the government’s steps towards monetary and fiscal policies,
market sentiment and other macro-economic variables. If it is found that borrowed funds
became cheap the firm may move to issue debt securities. It should be noted here that the firm
must operate under its debt capacity while designing its capital structure.
8. Firm’s Characteristics:
The size of the firm and creditworthiness are important factors to be consid-ered while
designing its capital structure. For a small company the management cannot depend much on
the debt because its creditworthiness is limited—they will have to depend on equity. For a
large concern, however, the benefit of capital gearing may be availed. Small firms have
limited access to various sources of funds. Even investors are reluctant to invest in small firms.
So the size and credit standing also determine capital structure of the firm.
14 Important Factors Affecting the Choice of Capital Structure:
1. Cash Flow Position: While making a choice of the capital structure the future cash flow
position should be kept in mind. Debt capital should be used only if the cash flow position
is really good because a lot of cash is needed in order to make payment of interest and
refund of capital.
2. Interest Coverage Ratio-ICR: With the help of this ratio an effort is made to find out how
many times the EBIT is available to the payment of interest. The capacity of the company
to use debt capital will be in direct proportion to this ratio. It is possible that in spite of
better ICR the cash flow position of the company may be weak. Therefore, this ratio is not
a proper or appropriate measure of the capacity of the company to pay interest. It is
equally important to take into consideration the cash flow position.
3. Debt Service Coverage Ratio-DSCR: This ratio removes the weakness of ICR. This shows
the cash flow position of the company. This ratio tells us about the cash payments to be
made (e.g., preference dividend, interest and debt capital repayment) and the amount of
cash available. Better ratio means the better capacity of the company for debt payment.
Consequently, more debt can be utilised in the capital structure.

13. 4. Return on Investment-ROI: The greater return on investment of a company increases its
capacity to utilise more debt capital
5. Cost of Debt: The capacity of a company to take debt depends on the cost of debt. In
case the rate of interest on the debt capital is less, more debt capital can be utilised and
vice versa.
6. Tax Rate: The rate of tax affects the cost of debt. If the rate of tax is high, the cost of
debt decreases. The reason is the deduction of interest on the debt capital from the profits
considering it a part of expenses and a saving in taxes. For example, suppose a company
takes a loan of 0ppp 100 and the rate of interest on this debt is 10% and the rate of tax
is 30%. By deducting 10/- from the EBIT a saving of in tax will take place (If 10 on
account of interest are not deducted, a tax of @ 30% shall have to be paid).
7. Cost of Equity Capital: Cost of equity capital (it means the expectations of the equity
shareholders from the company) is affected by the use of debt capital. If the debt capital
is utilised more, it will increase the cost of the equity capital. The simple reason for this is
that the greater use of debt capital increases the risk of the equity shareholders.
Therefore, the use of the debt capital can be made only to a limited level. If even after
this level the debt capital is used further, the cost of equity capital starts increasing
rapidly. It adversely affects the market value of the shares. This is not a good situation.
Efforts should be made to avoid it.
8. Floatation Costs: Floatation costs are those expenses which are incurred while issuing
securities (e.g., equity shares, preference shares, debentures, etc.). These include
commission of underwriters, brokerage, stationery expenses, etc. Generally, the cost of
issuing debt capital is less than the share capital. This attracts the company towards debt
capital.
9. Risk Consideration: There are two types of risks in business: (i) Operating Risk or Business
Risk: This refers to the risk of inability to discharge permanent operating costs (e.g., rent of
the building, payment of salary, insurance installment, etc), (ii) Financial Risk: This refers to
the risk of inability to pay fixed financial payments (e.g., payment of interest, preference
dividend, return of the debt capital, etc.) as promised by the company. The total risk of
business depends on both these types of risks. If the operating risk in business is less, the
financial risk can be faced which means that more debt capital can be utilised. On the
contrary, if the operating risk is high, the financial risk likely occurring after the greater
use of debt capital should be avoided.
10. Flexibility: According to this principle, capital structure should be fairly flexible. Flexibility
means that, if need be, amount of capital in the business could be increased or decreased
easily. Reducing the amount of capital in business is possible only in case of debt capital
or preference share capital. If at any given time company has more capital than as
necessary then both the above-mentioned capitals can be repaid. On the other hand,
repayment of equity share capital is not possible by thecompany during its lifetime. Thus,
from the viewpoint of flexibility to issue debt capital and preference share capital is the
best.

14. 11. Control: According to this factor, at the time of preparing capital structure, it should be
ensured that the control of the existing shareholders (owners) over the affairs of the
company is not adversely affected. If funds are raised by issuing equity shares, then the
number of company’s shareholders will increase and it directly affects the control of
existing shareholders. In other words, now the number of owners (shareholders) controlling
the company increases. This situation will not be acceptable to the existing shareholders.
On the contrary, when funds are raised through debt capital, there is no effect on the
control of the company because the debenture holders have no control over the affairs of
the company. Thus, for those who support this principle debt capital is the best.
12. Regulatory Framework: Capital structure is also influenced by government regulations.
For instance, banking companies can raise funds by issuing share capital alone, not any
other kind of security. Similarly, it is compulsory for other companies to maintain a given
debt-equity ratio while raising funds. Different ideal debt-equity ratios such as 2:1; 4:1;
6:1 have been determined for different industries. The public issue of shares and
debentures has to be made under SEBI guidelines.
13. Stock Market Conditions: Stock market conditions refer to upward or downward trends in
capital market. Both these conditions have their influence on the selection of sources of
finance. When the market is dull, investors are mostly afraid of investing in the share
capital due to high risk. On the contrary, when conditions in the capital market are
cheerful, they treat investment in the share capital as the best choice to reap profits.
Companies should, therefore, make selection of capital sources keeping in view the
conditions prevailing in the capital market.
14. Capital Structure of Other Companies: Capital structure is influenced by the industry to
which a company is related. All companies related to a given industry produce almost
similar products, their costs of production are similar, they depend on identical technology,
they have similar profitability, and hence the pattern of their capital structure is almost
similar. Because of this fact, there are different debt- equity ratios prevalent in different
industries. Hence, at the time of raising funds a company must take into consideration
debt-equity ratio prevalent in the related industry.