Question

Explain the following factors affecting the choice of capital structure of a company:
(i) Cost of Equity
(ii) Control
(iii) Stock Market Conditions

Hint:

A company’s capital structure is influenced by equity costs, control considerations, and prevailing stock market conditions, affecting its financial stability.

Answer 1

Factors Affecting the Choice of Capital Structure:
(i) Cost of Equity
- Increasing debt raises the financial risk faced by equity holders, leading to a higher expected rate of return on equity.
- If debt usage exceeds a certain level, cost of equity may rise sharply, reducing share prices despite higher earnings per share (EPS).
(ii) Control
- Debt financing does not dilute ownership, helping management retain control over the company.
- Issuing new equity shares reduces the promoters' holding, making the company more vulnerable to takeovers.
(iii) Stock Market Conditions
- In a bullish market, investors are more willing to buy equity shares at higher prices, making equity financing easier.
- In a bearish market, raising equity capital is difficult, leading firms to prefer debt financing instead.