"Capital structure decision is essentially optimisation of risk-return relationship." Comment.
Answers
SOLUTION :
“Capital structure decision is essentially optimisation of risk return relationship”
A company cannot depend on single source of fund for a longer period of time in the interest of equity shareholders and company itself.
We can understand the correct proportion in two different situations :
When the company's financially weak :
If a company cannot afford fixed commitments of interest and repayment of principal amount known as financial risk in time it should prefer more of equity funds than debt funds in the capital structure as in case if earnings are insufficient or losses are borne, the shareholders cannot compel the company to pay dividend. In case if a company raises debt funds, it involves financial risks and default in payment of financial commitment may lead the company in the situation of liquidation.
When the company is financially strong :
If a company can afford the payment of fixed commitments and repayment of principal amount of debts in time , it should prefer more of debt than equity in the capital structure. It will help the company to save tax as interest is the deductible from the profit before the payment of tax and save funds as it carries low floatation costs. Thus, earning per share is increased and wealth of equity shareholders is maximized.
Conclusion :
It is a financial strength of a company which decides the optimum amount of debt and equity in its capital structure.
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Answer:
Explanation:
It is a financial strength of a company which decides the optimum amount of debt and equity in its capital structure.