Capital structure refers to the mix of own and borrowed funds. The factors affecting the choice of capital structure are:

(A) Business Cycle

(B) Cost of debt

(C) Return on Investment

(D) Cost of Equity

Choose the correct answer from the options given below:

(B), (C) and (D) only

The correct answer is option 4- (B), (C) and (D) only.

Except business cycle, all others factors affect choice of capital structure. Business cycle affects working capital requirement.

Business Cycle: Different phases of business cycles affect the requirement of working capital by a firm. In case of a boom, the sales as well as production are likely to be larger and, therefore, larger amount of working capital is required. As against this, the requirement for working capital will be lower during the period of depression as the sales as well as production will be small.

OTHER OPTIONS

• Cost of Equity: Stock owners expect a rate of return from the equity which is commensurate with the risk they are assuming. When a company increases debt, the financial risk faced by the equity holders, increases. Consequently, their desired rate of return may increase. It is for this reason that a company can not use debt beyond a point. If debt is used beyond that point, cost of equity may go up sharply and share price may decrease in spite of increased EPS.

• Return on Investment (RoI): If the RoI of the company is higher, it can choose to use trading on equity to increase its EPS, i.e., its ability to use debt is greater.. RoI is an important determinant of the company’s ability to use Trading on equity and thus the capital structure.

• Cost of debt: A firm’s ability to borrow at a lower rate increases its capacity to employ higher debt. Thus, more debt can be used if debt can be raised at a lower rate.