Question

Give examples on the following factors affecting capital structure:

*Financial leverage

*Risk

*Growth and stability

*Retaining Control

* Cost of capital

*Cash flows

*Flexibility

*purpose of finance

*asset structure

Answer 1

1. Cash flows-
Business transactions involves cash coming in and going out of the business. The net amount of the cash or cash equivalents in and out of the business is known as cash flows. Increase in cash flows is the result of increasing business. This helps in increasing value for shareholders and utimately adds on to increasing the worth and goodwill of the business. Hence, the primary aim of any business shld be to increase the cash flows.
Example- movement of cash in the business involves money obtained from selling goods or services. Movement of cash outside the business could be through purchase of raw materials, equipments payment of expenses like wages, salary , rent etc. The net amounts results in the cash flows.

2. Purpose of finance-
Finance is very critical for any business organisation. It is very essential for the basic survival of the business. Finance is required for survival, stability as well as growth of the organization. Businesses require finance to procure raw materials, equipments, payment of expenses, dividends, maintenance of equipments and various other expenses. It is very crucial for businesses to invest the money in right proportion and at right places so as to maximise the returns.

3. Cost of capital-
Cost of capital refers to the cost of borrowing money. Businesses require money to run the business, stabilize as well as grow in order to stay in the competition. For this they have to borrow money from outside through various sources such in the form of equity and debt. On this they have to provide returns to them in the form of interest and dividend. This is the cost of capital. Businesses must ensure to have the correct mix of debt and equity in order to reduce the cost of capital.

4.Financial leverage-

Financial leverage is also known as the Leverage or Trading on Equity, which refers to the use of debt to acquire additional assets. The use of financial leverage to control a greater amount of assets (by borrowing money) will cause the returns on the owner's cash investment.

• an increase in the value of the assets which will result in a larger gain on the owner's cash, when the loan interest rate is less than the rate of increase in the asset's value.
• a decrease in the value of the assets will result in a larger loss on the owner's cash.

Formula: Leverage = total company debt/shareholder's equity.

5. Risk-

Risk is the potential for uncontrolled losses of any asset or value of things. Values (such as physical health, social status, emotional well-being, or financial wealth) can be gained or lost when taking risk resulting from a given action or inaction, foreseen or unforeseen (planned or not planned). Risk can also be defined as the intentional interaction with uncertainty. Uncertainty is a potential, unpredictable, and uncontrollable outcome; risk is an aspect of action taken in spite of uncertainty.

Risk perception is the subjective judgment people make about the severity and probability of a risk, and may vary person to person. Any individual carries some risk to gain the good amount of profit.

6. Reatinning control-

Retaining control means to keep or to continue to have something, especially a position or money, which will help the investor to manage the capital structure of their organization. Proper controlling of the money can lead to the success of the organisation if the individual manages to make the proper flow of the cash flow.

7. Flexibility-

Flexibilty is an important factor for capital structure. Business in todays era is very dynamic. The requirement for funds vary from time to time. Sometimes the business may require additional funds and sometimes less funds. Hence, it must keep flexibility in the capital structure so as to ensure that funds can be made available as an when needed. It flexibility is not maintained, it may lead to borrowing at higher rates thereby increasing the cost to the business.

8. Growth and stabilty.
Every business tries the best to strive in the competition in oder to stabilise as well as grow. For this it requires funds. Funds can be raised through various sources such a loans , shares, debentures etc. The funds must be raised in such a manner in order to reduce the cost as well as risk of borrowing. If it does not do so, the growth may be hamperred and the very existence for the business may come at a stake. Hence, it is an important factor for determining the capital structure.