Question

Explain how (i) Risk consideration and (ii) Tax Rate affect the choice of capital structure.

Answer 1

(i) Risk of consideration While deciding the capital structure, risk must be analysed and considered.

Total risk consists of two types of risks:

(a)Financial risk It refers to a position when a company is unable to meet its fixed financial charges namely, interest payment, preference dividend and payment obligations. It arises when a company borrows. Use of debt increases the financial risk of a business.

(b)Business risk It depends upon fixed operating costs. Higher fixed operating cost means higher business risk and vice-versa. If a firm’s operating risk is lower, its capacity to use debt is higher and vice-versa.

(ii)Tax rate Interest is a deductible expense. Cost of debt is affected by the tax rate. A higher tax rate

makes debt relatively cheaper and increases its attraction in relation to equity.