## Factors Affecting Capital Structure

Several factors and guiding principles influence how a firm designs its mix of debt and equity.

### Key Factors / Principles

1. Financial leverage (Trading on Equity): The use of long-term fixed-interest-bearing debt and preference share capital alongside equity share capital is called financial leverage or trading on equity.

2. Growth and stability of sales: Capital structure is highly influenced by sales growth and stability. If sales are expected to remain fairly stable, the firm can safely raise a higher level of debt.

3. Cost Principle: An ideal capital structure minimises the cost of capital and maximises EPS. Debt is cheaper than equity because interest is tax-deductible, whereas dividends are not.

4. Risk Principle: Place more reliance on common equity than on excessive debt to finance capital requirements, so as to limit financial risk.

5. Control Principle: Design the structure so that existing management control and ownership remain undisturbed (e.g. avoid issuing equity that dilutes control).

6. Flexibility Principle: Choose a combination of financing sources that can be easily adjusted to future changes in the firm's need for funds.

⚠️ Common exam mistakes

Mixing up the Cost Principle (minimise cost / maximise EPS) with the Risk Principle (rely more on equity to limit risk) — they pull in different directions.
Forgetting that the Control Principle is about avoiding dilution of existing ownership, not about cost.
Assuming volatile-sales firms can carry high debt — only stable-sales firms can safely raise higher debt.

Reference:

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