Q. 2

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

Answer :

Capital structure may be defined as combination of debt and equity in capital.

The capital structure should be so designed that –

It should minimise cost of capital

It should reduce risk

It should give required flexibility

It should provide required control to owners

It should enable the company to have adequate Finance

Risk is the variability in income. The risk may be of two types - business risk and financial risk.

Business risk is the situation when EBIT may vary due to change in capital structure

Financial risk is the variability in EPS due to change in financial structure.

The theory of optimal capital structure states that as the level of debt is raised the value of firm can be raised up to a certain extent so debt should be increased up to a particular level.

An optimal capital structure is when the proportion of debt and equity has been so maintained that it results in increase in the value of equity shares.

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