Factors Affecting Capital Structure

## Factors Affecting Capital Structure

When a firm decides its capital structure, it must evaluate multiple factors. These can be grouped as:

### 1. Financial Leverage / Trading on Equity

• Using debt and preference capital alongside equity.
• If Return on Investment (ROI) > Cost of Debt → EPS increases → Debt is beneficial.
• If ROI < Cost of Debt → EPS falls → Debt is harmful.
• Needs careful calibration; excessive leverage amplifies losses.

### 2. Growth and Stability of Sales

• Stable, growing sales → Firm can service fixed interest payments confidently → More debt is safe.
• Fluctuating or declining sales → Uncertain cash flows → Cannot reliably service debt → Less debt is safer.

### 3. Cost Principle

• The capital structure should minimise the overall cost of capital (WACC) and maximise EPS.
• Debt is preferred where possible due to tax-deductible interest.

### 4. Risk Principle

• High fixed interest commitments increase financial risk.
• If earnings fluctuate, debt can erode shareholder value.
• More equity reduces risk but at the cost of higher WACC.

### 5. Control Principle

• Issuing new equity → Dilutes ownership → Existing shareholders lose proportionate control.
• Debt → No dilution of control, but increases the risk of financial distress.
• Promoters seeking to maintain control prefer debt.

### 6. Flexibility Principle

• A firm should be able to adjust its capital structure as conditions change.
• Debt is more flexible: Can be refinanced, repaid, or renegotiated.
• Equity is permanent: Cannot be 'returned' (except through buybacks, which have restrictions).

### 7. Other Considerations

• Industry nature: Capital-intensive industries (steel, infrastructure) use more debt; tech firms use more equity.
• Timing: Issue equity when markets are bullish (higher prices); issue debt when interest rates are low.
• Competition: Highly competitive industries prefer equity to avoid fixed charges during price wars.

### Quick Summary Table