Factors affecting capital structure

How much debt a firm can safely take depends on many factors.

• Cash flow position: cash must cover all fixed payments (interest, repayments) with a buffer to spare.
• Interest coverage ratio (ICR) = EBIT ÷ interest. The higher, the safer.
• Debt service coverage ratio (DSCR): it also includes repayments of the loan and preference dividends. A higher DSCR means the firm can carry more debt.
• Return on investment: debt pays only if RoI is above the cost of debt.
• Cost of debt, after tax: since interest is tax-deductible, debt at 12% with tax at 25% really costs 12% × (1 − 0.25) = 9%. A higher tax rate makes debt relatively cheaper.
• Cost of equity and floatation costs.
• Risk: the firm's business risk plus the financial risk of debt; together they must stay manageable.
• Flexibility: keep some borrowing power for future needs.
• Control: debt does not dilute the owners' control; new shares do.
• Regulatory framework: the rules of SEBI and lenders.
• Stock market conditions: in a bullish (rising) market, firms prefer to issue equity.
• Capital structures of other companies in the industry, as a guide, but not to be copied blindly.