Page 3 - Lesson Note 4

It is one step ahead ICR, i.e., ICR covers to pay the obligation to pay back

interest on debt but DSCR takes care of return of interest as well as
principal repayment.

If DSCR is high then company can have more debt in capital structure as
high DSCR indicates ability of company to repay its debt but if DSCR is less

then company must avoid debt and depend upon the equity capital only.
4. Return on investment.
Return on investment is another crucial factor which helps in deciding the

capital structure. If return on investment is more than rate of interest then

company must prefer debt in its capital structure where as if return on
investment is less than rate of interest to be paid on debt, then company
should avoid debt and rely on equity capital.

5. Cost of debt.
If firm can arrange borrowed fund at lower rate of interest then it will

prefer more debt as compared to equity.
6. Tax rate.

High tax rate makes debt cheaper as interest paid to debt security holders
is subtracted from income before calculating tax whereas companies have

to pay tax on dividend paid to share holders.
So high end tax rate means prefer debt where as at low tax rate we can
prefer equity in capital structure.

7. Cost of equity.
Another Factor which helps in deciding capital structure is cost of equity.

Owners or equity shareholders expect a return on their investment i.e.
Earnings per share.

As far as debt is increasing earnings per share, then we can include it in
capital structure but when EPS starts decreasing with inclusion of debt then

we must depend upon equity share capital only.
8. Flotation costs.

Flotation cost is the cost involved in the issue of shares or debentures.
These costs include the cost of advertisement, underwriting statutory fees

etc. Issue of shares, debentures requires more formalities as well as more