Question

(a) Explain the following factors affecting the requirement of fixed capital of a company:

• [(i)] Choice of technique
• [(ii)] Financing alternatives
• [(iii)] Growth prospects

OR (b) Explain the following factors affecting choice of capital structure of a company:

• [(i)] Cost of equity
• [(ii)] Control
• [(iii)] Stock market conditions

Hint:

Fixed capital is about "what you buy"; capital structure is about "how you fund it". Both decisions must be aligned with long-term goals and risk preferences of the business.

Answer 1

(a) Influences on Fixed Capital Needs:

• Technology Selection: A business's fixed capital requirement is significantly influenced by its choice between capital-intensive and labour-intensive methods. Businesses utilizing capital-intensive techniques (e.g., automated manufacturing facilities) necessitate greater investment in fixed assets like machinery, equipment, and structures. Conversely, labour-intensive operations (e.g., artisanal crafts) demand less fixed capital, prioritizing human labour over mechanical assets.
• Financing Avenues: The availability of leasing or rental options can substantially decrease the necessity for substantial fixed asset investments. For instance, leasing machinery instead of purchasing it outright reduces the demand for fixed capital. Similarly, businesses may contract out services like transportation, avoiding the need to acquire vehicles.
• Expansion Potential: Enterprises with strong growth prospects typically require more substantial fixed capital. A company anticipating future expansion or diversification might preemptively invest in additional production capacity, land, or cutting-edge technology. Start-ups aiming for rapid market scaling will likely need considerable initial investment in fixed infrastructure.

OR (b) Determinants of Capital Structure Choice:

• Equity Cost: While equity represents a perpetual funding source, it is generally more expensive than debt. This is due to the non-tax-deductibility of dividends, unlike interest, and the higher return expectations of shareholders owing to increased risk. Businesses must carefully consider this cost when establishing their funding mix.
• Ownership Control: Issuing additional equity can diminish the influence of existing shareholders, particularly founders. Consequently, owners seeking to maintain absolute control may favour debt financing, even if it incurs higher costs. Capital structure therefore hinges on the degree to which owners are prepared to cede equity.
• Securities Market Climate: During periods of market optimism (bullish markets), companies often favour equity issuance, as investors are more inclined to invest and asset valuations are elevated. Conversely, in adverse or volatile market conditions (bearish markets), raising equity becomes challenging, prompting firms to consider debt. Thus, prevailing market sentiment strongly impacts capital structure decisions.