Question

it lists the sources of long-term financing used by companies to finance investment capital, in order of lowest to highest cost, and explains what is the factor that causes one source of capital to be more or less expensive than other sources.

Answer 1

Factor that causes one source of capital to be more or less expensive than other sources are as follows :

1. Cash Flow Position: While making a choice of the capital structure the future cash flow position should be kept in mind. Debt capital should be used only if the cash flow position is really good because a lot of cash is needed in order to make payment of interest and refund of capital.
2. Interest Coverage Ratio-ICR : With the help of this ratio an effort is made to find out how many times the EBIT is available to the payment of interest. The capacity of the company to use debt capital will be in direct proportion to this ratio. It is possible that in spite of better ICR the cash flow position of the company may be weak. Therefore, this ratio is not a proper or appropriate measure of the capacity of the company to pay interest. It is equally important to take into consideration the cash flow position.
3. Debt Service Coverage Ratio-DSCR: This ratio removes the weakness of ICR. This shows the cash flow position of the company.This ratio tells us about the cash payments to be made (e.g., preference dividend, interest and debt capital repayment) and the amount of cash available. Better ratio means the better capacity of the company for debt payment. Consequently, more debt can be utilised in the capital structure.
4. Return on Investment-ROI: The greater return on investment of a company increases its capacity to utilise more debt capital.
5. Cost of Debt: The capacity of a company to take debt depends on the cost of debt. In case the rate of interest on the debt capital is less, more debt capital can be utilised and vice versa.
6. Tax Rate: The rate of tax affects the cost of debt. If the rate of tax is high, the cost of debt decreases. The reason is the deduction of interest on the debt capital from the profits considering it a part of expenses and a saving in taxes.