Explain the following factors affecting the choice of capital structure of a company :
(i) Interest coverage ratio
(ii) Cost of debt
Explain the following factors affecting the choice of capital structure of a company :
(i) Interest coverage ratio
(ii) Cost of debt
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Solution and Explanation
Capital structure is the mix of debt and equity used to finance a firm.
We explain how the interest coverage ratio and the cost of debt affect the choice of this mix.
Step 2: (i) Interest coverage ratio: the idea:
The interest coverage ratio is EBIT divided by interest. It shows how many times EBIT covers the interest due.
Step 3: (i) Interest coverage ratio: the effect:
A higher ratio means the firm can pay interest easily, so it can safely take more debt.
A lower ratio shows the firm may fail to pay interest, so it should use less debt and more equity.
Step 4: (ii) Cost of debt: the idea:
The cost of debt is the rate of interest the firm pays on its borrowings.
Step 5: (ii) Cost of debt: the effect:
If the cost of debt is low, the firm prefers more debt in its capital structure.
If the rate of interest is high, the firm uses less debt and relies more on equity.
Final Answer:
A higher interest coverage ratio and a lower cost of debt support more debt in the capital structure. The opposite favours more equity.
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‘Quality Foods Ltd.’, a company manufacturing packaged snacks has been in business for the last 10 years. It enjoys a good reputation and has a loyal customer base. This financial year, the profits of the company increased manifold as the company introduced a new range of baked snacks that became very popular. As the year came to an end, the company had to decide how much dividend to pay to its shareholders. In view of the above and with the understanding that investors, in general, view an increase in dividend as good news and stock prices react positively to it, the Board of Directors were keen on declaring a high dividend. However, the Chief Finance Officer of the company pointed out that they need to keep many considerations in mind before declaring dividend. He drew the attention of the Board of Directors to the loan that the company has taken, containing a clause that imposes restriction on the payment of dividend. Further, he pointed out that even though the profits were high, a large amount of money was tied to the amounts receivables from the debtors. Without enough cash in hand, announcing a high dividend may not be practical. He also reminded the Board of Directors that ‘Quality Foods Ltd.’ was planning to expand into the breakfast cereal market. Since this new project will require a huge investment, the company will need to retain more money out of their earnings to finance it.
(a) Identify and explain any two factors affecting dividend decision that would have influenced the decision of the Board of Directors to pay a high dividend.
(b) Identify and explain any two factors to which the Chief Finance Officer drew the attention of the Board of Directors.
A position when a company is unable to meet its fixed financial charges like interest payment, dividend on preference shares and repayment obligations is referred to as ______ .
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