Question

Explain how the following factors affect the choice of capital structure of a company: (i) Flexibility
(ii) Cost of equity

Answer 1

Factors affecting choice of capital structure: (i) Flexibility: - If a firm uses its debt potential to the full, it loses flexibility to issue further debt. - It must maintain some borrowing power to take care of unforeseen circumstances. (ii) Cost of equity: - When a company increases debt, the financial risk faced by the equity holders increases. Consequently, their desired rate of return may increase. - If debt is used beyond a level, the cost of equity may go up and share prices may decrease sharply despite increased earning per share (EPS).