The Capital Structure Essay Example | Topics and Well Written Essays - 2000 words - 17

The Capital Structure - Essay Example Besides this, debt is considered cheaper by the providers of finance and it attracts tax relief on interest payments. The greater the level of debt, the more will be the financial risk to the shareholder of the company. Hence the return required would be higher. This also helps in establishing the gearing mix of a company. The higher a company is geared, the higher would be the risk involved. There are many factors that contribute towards the availability of different sources of funds. Gearing is one major issue which has a critical effect on the capital structure of a company. The higher a company is geared, the more difficult it would be for the company to raise debt finance as the institution giving out the debt would be exposed to greater risk. One view is that there is an optimal capital mix at which the average cost of capital, weighting according to the different forms of capital employed, is minimised. As for gearing increases, the return expected by ordinary shareholders beg in to rise in order to compensate them for the risk resulting from a larger share of profits going to the providers of debt. The cost is comparatively lower than the cost of equity because debt is relatively less risky from debt holder’s point of view as a debt would give the debt holder the legitimate amount of debt to which he/she is entitled to, besides the interest income, the debt can be made secure. Interest rates are usually higher on long-term debt as compared to short-term debts as the lender would require the compensation for the increased period of time he/she is deprived of his/her funds. A company finds itself committed to long-term debts with adverse interest charges and huge penalties if the debt is paid up early. Inflation and uncertainty about changes in future interest rates are one of many reasons why companies hesitate to borrow long-term debts at increased rates of interest.