Question

'Capital structure decision is essentially optimisation of risk-return relationship'. Comment.

Answer 1

Capital structure decision is related to the proportion of debt and equity in the capital structure. What proportion is maintained decides the cost and risks.

This is because both equity and debt differ significantly in their risk and returns.

(i) On one side, equity is a riskless source, but it has no benefit of tax deductibility of dividend, and dividends are paid out of profits after tax.

(ii) On the other hand, debentures are paid a fixed rate of interest. The interest paid is deductible from the income for tax calculation purposes. Thus, it creates a higher rate of return for equity shareholders.