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:
Answer & explanation
Correct answer: option 4
The correct answer is Option (4) → (B), (C) and (D) only
Capital structure is the mix of owners’ funds (equity) and borrowed funds (debt). Many factors affect this choice, such as cash flow position, interest coverage ratio, return on investment, cost of debt, tax rate and cost of equity.
(A) Business Cycle — Not a factor of capital structure (Incorrect). The business cycle is a factor of working capital. In a boom, sales and production rise, so the firm needs more working capital. It is not in the list of capital structure factors.
(B) Cost of debt — A factor (Correct). If a firm can borrow at a lower rate of interest, it can use more debt.
(C) Return on Investment — A factor (Correct). If the return on investment is high, the firm can use more debt to raise its earning per share. Using debt in this way is called trading on equity.
(D) Cost of Equity — A factor (Correct). More debt means more risk for the shareholders. Then they expect a higher return. So a firm cannot use debt beyond a point.
NCERT (2026-27 Edition): “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. …” “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.” “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. …” “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. …” |