Business Environment — Business Studies STD 12 Commerce — Question

Capital structure is simply referred to as the combination of debt and equity used by a company for financing its fund requirements. Algebrically Capital Structure is equal to Debt Equity or Debt + equity.
Two factors which affect the capital structure of a company are:

1. Equity cost: The rate of return expected by the shareholders is directly related to the risk associated with their investment. As the financial risk faced by the company increases, the shareholders’ expectation of rate of return increases and vice versa.

Now, as the company increases the component of debt, the financial risk faced by it also increases. Therefore, the shareholders’ expectation of rate of return increases. This relationship suggests that a company cannot increase the component of debt in its capital structure beyond a certain point.

2. Floatation cost: It refers to the cost of raising funds such as broker’s commission and underwriting commission. The higher the floatation cost involved in raising funds from a particular source, the lower is its proportion in the capital structure. For instance, if public issue of shares involves higher floatation cost than debt, then the company would option for more of debt and less of equity in the capital structure.