Capital structure refers to the mix between owners and borrowed funds. It can be calculated as (Debt/Equity).
Debt and equity differ significantly in their cost and riskiness for the firm. Cost of debt is lower than cost of equity for a firm because lender’s risk is lower than equity shareholder’s risk since lenders earn on assured return and repayment of capital and therefore they should require a lower rate of return.
Debt is cheaper but is riskier for 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. Higher use of debt increases the fixed financial charges of business. As a result, increased, use of debt increases the financial risk of a business.
Capital structure of a business thus affects both the profitability and the financial risk. A capital structure will be said to be optimal when the proportion of debt and equity is such that it results in an increase in the value of the equity share.
