Q.“Capital structure decision is essentially optimisation of risk-return relationship.” Comment.

The statement is correct. Capital structure refers to the mix of debt and equity used by a company to finance its operations. The core of this decision lies in balancing risk and return.

Debt is a cheaper source of funds because interest is tax-deductible, which increases the return for shareholders (higher EPS). However, debt also carries a fixed financial obligation. Using more debt increases the financial risk of the firm — the risk of defaulting on interest payments.

Equity, on the other hand, is more expensive but carries no fixed obligation, so it reduces financial risk. The goal of a financial manager is to find the optimal capital structure — the specific debt-equity mix that minimises the overall cost of capital and maximises the value of the firm. This is precisely an exercise in optimisation: you trade off the higher return from cheaper debt against the higher risk it brings.

Capital structure refers to the mix between owners' funds (equity) and borrowed funds (debt) that a company uses to finance its long-term operations. When a company decides that mix -- expressed as the debt-equity ratio, Debt divided by Equity, or as the proportion of debt in total capital -- it is not merely picking sources of money; it is choosing how much financial risk to carry in exchange for how much potential return. That is why the decision is best described as an optimisation of the risk-return relationship.

The reasoning rests on how debt and equity differ. The cost of debt is lower than the cost of equity, because a lender's risk is lower (a lender earns an assured return and gets the principal back) and because interest on debt is a tax-deductible expense, whereas dividends are paid out of after-tax profit. So increasing the use of debt tends to lower the overall cost of capital. But debt is also riskier for the business: interest and repayment of principal are obligatory, and any default can force the firm into liquidation. Equity carries no such compulsion and is, from the firm's point of view, riskless. Higher use of debt therefore raises the fixed financial charges and increases the financial risk -- the chance that the firm will fail to meet its payment obligations.

This is the trade-off at the heart of the decision. As the proportion of debt (financial leverage) rises, the cost of funds falls because cheaper debt is being used, but financial risk climbs. The impact on the equity shareholders can be seen through EBIT-EPS analysis: when the return on investment is above the interest rate, more debt lifts the earnings per share (favourable leverage); when it is below the interest rate, more debt drags EPS down (unfavourable leverage).

So the "best" capital structure is not the one with the lowest cost, nor simply the one with the least risk. A capital structure is optimal when the proportion of debt and equity is such that it increases the value of the equity share -- in other words, when it maximises the shareholders' wealth. The finance manager has to weigh the extra return each additional rupee of debt can bring against the extra risk it adds, and choose the risk-return combination that lifts the market value of the firm.