The factor affecting the capital structure are :
(i) Cost of debt : Cost of debt means the expected rate of return of lenders on debt capital for assuming risk. It is the rate of interest payable on debentures or loans.
More debt can be used in capital structure if rate of interest on debt is low. Debt is cheaper source of finance because interest on debt is a tax deductible expense.
(ii) Cost of equity : Cost of equity means the expected rate of return on equity capital for assuming risk. It is the rate of dividend on shares. When a company increases debt, the financial risk faced by the equity holders also increases. Consequently, their desired rate of return may increase. Therefore, a company cannot use debt beyond a point. If debt is used beyond that point, cost of equity may go up sharply and share price may decrease. Hence, for maximisation of shareholders wealth, debt can be used only up to a level.
(iii) Floatation costs : Cost of raising funds is called floatation cost, e.g., costs of advertising, printing prospectus, etc. Getting a loan from a financial institution may not cost so much. These considerations may also affect the choice between debt and equity.
(iv) Cash flow position : A company uses more debt if it can generate enough cash inflows to pay interest on debt. On the contrary, it would be quite risky to use more debt if cash inflows are unstable.
(v) Control : Debt normally does not cause a dilution of management's control over the business while issue of more equity may reduce the management's holding in the company. There is a threat of takeover also. So, if the management of a company is interested in retaining control over the affairs of the business, it will use more debt (but only up to a level)
(vi) Return on Investment (ROI) : If the ROI of the company is high and is greater than rate of interest on debt, it can use more debt to increase the profit earned by equity shareholders. This is called Trading on Equity'.