Capital structure decision is essentially optimization of risk-return

1.	Capital structure decision is essentially optimization of risk-return relationship. Comment.
Answer» i. Capital structure decision is related to proportion of debt (risk) and equity (return). ii. Debt is cheaper but is more risky for a business because payment of interest and the return of principal is obligatory for the business. Any default in meeting these commitments may force the business to go into liquidation. There is no such compulsion in case of equity, which is therefore, considered riskless for the business. iii. Debt component in the total capital generates higher return for equity shareholders as interest payable on debt is deductible from earning before tax payment. iv. Thus, capital structure decision affects risk as well as return. So, it is true capital structure decision is essentially optimization of risk-return relationship.

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

Answer»

i. Capital structure decision is related to proportion of debt (risk) and equity (return).

ii. Debt is cheaper but is more risky for a business because payment of interest and the return of principal is obligatory for the business. Any default in meeting these commitments may force the business to go into liquidation. There is no such compulsion in case of equity, which is therefore, considered riskless for the business.

iii. Debt component in the total capital generates higher return for equity shareholders as interest payable on debt is deductible from earning before tax payment. iv. Thus, capital structure decision affects risk as well as return. So, it is true capital structure decision is essentially optimization of risk-return relationship.

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