1. Trading on Equity: It refers to the increase in profit earned by the equity shareholders due to the presence of fixed financial charges like interest. Trading on equity happens when the rate of earning of an organisation is higher than the cost at which funds have been borrowed and as a result equity shareholders get higher rate of dividend per share. The use of more debt along with the equity increases EPS as the debt carries fixed amount of interest which is tax deductible. Let us understand with an example-
Thus the EPS of company Y and Z is higher than company X because of application of ‘Trading on Equity’
2. Cash Flow Position: In case a company has strong cash flow position then it may raise finance by issuing debts, as they are to be paid back after some time.
3. Interest Coverage Ratio: It refers to the number of times earning before interest and taxes of a company covers the interest obligation. High interest coverage ratio indicates that company can have more of borrowed funds. Formula for calculating ICR = EBIT/interest.
4. Return on Investment: If return on investment is higher than the rate of interest on debt then it will be beneficial for a firm to raise finance through borrowed funds.
5. Floatation Cost: The cost involved in issuing securities such as brokers commission, under writer’s fees, cost of prospectus etc. is called floatation cost. While selecting the source of finance, flotation cost should be taken into account.
6. Control: When existing shareholders are ready to dilute their control over the firm then new equity shares can be issued for raising finance but in reverse situation debts should be used.
7. Tax Rate: Interest on debt is allowed as a deduction; thus in case of high tax rate, debt is preferred over equity but in case of low tax rate more preference is given to equity.
8. Cost: The cost of raising funds from different sources are different. The cheapest source should be selected.
9. Risk: The risk associated with different sources is different. More risk is associated with borrowed funds as compared to owner’s fund as interest is paid in it and it is repaid also, after a fixed period of time or on expiry of its tenure
10. Period of Finance: For permanent capital requirement, Equity shares must be issued as they are not to be paid back and for long and medium term requirement, preference shares or debentures can be issued.
