--- title: "Capital structure; cash flowability, leverage ratio" subject: "Project Engineering" chapter: 6 key: "semester_7/project_engineering:capital-structure-cashflowability-leverage" source: https://www.bctengineer.com/q/semester_7/project_engineering/capital-structure-cashflowability-leverage site: BCT Engineering --- # Capital structure; cash flowability, leverage ratio Project Engineering · Chapter 6: Introduction to Project Financing - Asked in: 2067 Asar (old course), 8 marks - Answer checked by Claude Opus 5.5 (high effort) on 2026-10-14 - Page: https://www.bctengineer.com/q/semester_7/project_engineering/capital-structure-cashflowability-leverage - Whole chapter: https://www.bctengineer.com/md/semester_7/project_engineering/chapter-6 ## Question Define capital structure planning. Explain in brief cash flowability, leverage ratio, flexibility and marketability of the company. ## Short answer Capital structure planning decides the optimal mix of debt and equity to minimize cost and maximize value. Cash flowability is the ability to generate cash for servicing debt; leverage ratio compares debt to equity and impacts EPS; flexibility allows future financing without strain; marketability is the ease of selling securities in the market. ## Answer #### Capital structure planning **Capital structure** is the mix of long-term sources of funds (equity shares, preference shares, retained earnings and long-term debt) used by a firm to finance its total capital. **Capital structure planning** is the process of deciding the best proportion of these sources so that the cost of capital is lowest and the value of the firm and return to shareholders are highest. #### Cash flowability The ability of the firm to generate sufficient cash to pay interest, tax, loan instalments and dividends. Measured by interest coverage ratio (EBIT/interest) and debt service coverage ratio. Strong, stable cash flow permits more debt; weak cash flow needs more equity. #### Leverage ratio The leverage ratio shows how much debt the firm uses compared to equity (debt-equity ratio, debt ratio = debt/total capital). - Positive leverage: if return on investment is greater than the interest rate, debt increases EPS (trading on equity). - High leverage increases the risk of default if earnings fall. A suitable level is chosen from the earnings and the risk the firm can bear. #### Flexibility The capital structure should allow the firm to raise more funds when needed, without difficulty and at an acceptable cost. This needs unused borrowing power, low fixed commitments, and options like redeemable or convertible securities. #### Marketability It is the ease with which the firm can sell its securities in the capital market. It depends on the condition of the market (boom or recession), investor demand, the firm's reputation and the timing of issue. In a strong share market, equity is issued; when share prices are low, debt is preferred. ## Check yourself The answer's key points as multiple-choice questions, with the correct option and why. 1. What is the aim of capital structure planning? A. Choosing the mix of long-term funds so cost of capital is lowest and firm value is highest B. Maximising only the short-term borrowing of the firm C. Deciding the day-to-day working capital level D. Distributing all profit as dividend Answer: A. It decides the best proportion of long-term sources to minimise cost of capital and maximise firm value and shareholder return. (Key point: Capital structure planning) 2. A firm with strong, stable cash flow should generally: A. Use more equity because debt is unsafe B. Be able to take more debt C. Avoid paying interest D. Issue only preference shares Answer: B. Strong, stable cash flow lets the firm service interest and instalments, so it permits more debt; weak cash flow needs more equity. (Key point: Cash flowability) 3. When does debt increase EPS (positive leverage)? A. When return on investment is less than the interest rate B. When the tax rate is zero only C. When return on investment is greater than the interest rate D. When dividends are not paid Answer: C. If the investment earns more than the interest cost, the surplus goes to shareholders, raising EPS (trading on equity). (Key point: Leverage and EPS) 4. Which statement about marketability is correct? A. Debt is preferred when share prices are high B. Marketability is the firm's unused borrowing power C. It is measured by the interest coverage ratio D. Equity is issued in a strong share market and debt is preferred when share prices are low Answer: D. Marketability is the ease of selling securities and depends on market conditions; equity suits strong markets, debt suits low share prices. 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