Capital Structure and Risk-Return Tradeoff

The capital structure of a firm should be designed in such a way that it keeps the total risk of the firm to the minimum level. The financial or capital structure decision of a firm to use a certain proportion of debt or otherwise in the capital mix involves two types of risks:

  1. Financial Risk: The financial risk arise on account of the use of debt or fixed interest bearing securities in its capital. A company with no debt financing has no financial risk. The extent of financial risk depends on the leverage of the firm’s capital structure. A firm using debt in it capital has to pay fixed interest charges and the lack of ability to pay fixed interest increases the risk of liquidation. The financial risk also implies the variability of earning available to equity shareholders.
  2. Non-Employment of Debt Capital (NEDC) Risk: If a firm does not use debt in its capital structure, it has to face the risk arising out of non-employment of debt capital. The NEDC risk has an inverse relationship and vice versa. A firm that does not use debt cannot make use of financial leverage to increase its earnings per share: it may also lose control by issue or more and more equity; the cost of floatation of equity may also be higher as compared to costs of raising debt.

Thus a firm has reach a balance (trade-off) between the financial risk and risk of non-employment of debt capital to increase its market value.

Capital Structure and Risk-Return Tradeoff

The finance manager, in trying to achieve the optimal capital structure has to determine the minimum overall total risk and maximize the possible return to achieve the objective of higher market value of the firm.

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