Question

Relish Limited"is a name in the food industry reckoned with. It runs over 150 franchises
in India and around the world. It is one of the first restaurant to offer the Punjabi cuisine to the
rest of the world and many other famous dishes including Malai Kofta, Tandoori chicken, Butter
Chicken and Dal makhni. Now the company has decided to make an entry into the branded and
packaged foods business in the market with the series of new launches. The company is
planning to set up a composite food manufacturing facility in Bengaluru shortly, involving an
investment of up to Rs 700 crores out of which Rs 400 crores will be raised through Equity so as
to make its capital structure optimal.
(6)
In context of the above case:
(a) Outline the concept of Capital structure. When is a capital structure of a company said to
be optimal?
(b) Compute the value of financial leverage only with reference to the fresh capital being
raised by the company.
(c) How does financial leverage affect the cost of capital and financial risk of a business?​

Answer 1

Answer:

The optimal capital structure of a firm is the best mix of debt and equity financing that maximizes a company's market value while minimizing its cost of capital. In theory, debt financing offers the lowest cost of capital due to its tax deductibility.

The formula for calculating financial leverage is as follows: Leverage = total company debt/shareholder's equity.

Impact on Return on Equity

At an ideal level of financial leverage, a company's return on equity increases because the use of leverage increases stock volatility, increasing its level of risk which in turn increases returns.