Question

"Capital structure decision is essentially optimization of risk/return relationship". Comment.

Answer 1

Capital structure decision is related to 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 fixed rate of interest, the interest paid are deductible from the income for tax calculation purposes. Thus, it creates a higher rate of return for equity shareholders.

However, debt is more rewarding in terms of increase in the wealth of shareholders, but increases the risk too. Thus, reckless use of debt also is unfavourable and sometimes, may even force the company to go into liquidation. Thus, capital structure should be so formed, which optimises the risk-return relationship.