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

Determinants of Capital Structure:
(i) Cost of Equity
- Increased debt escalates financial risk for shareholders, necessitating a higher expected equity return.
- Excessive debt can sharply elevate the cost of equity, potentially depressing stock prices despite enhanced earnings per share (EPS).
(ii) Control
- Debt financing preserves ownership stakes, enabling management to maintain company control.
- Issuing new equity dilutes promoters' holdings, increasing susceptibility to hostile takeovers.
(iii) Stock Market Conditions
- A buoyant market encourages equity issuance due to investor willingness to purchase shares at elevated valuations.
- A declining market makes equity capital acquisition challenging, thus favoring debt financing.