Risks Involved in Capital Structure Decisions

This article throws light upon the two main types of risks involved in capital structure decision of a firm. The types are: 1. Financial Risk 2. Non-Employment of Debt Capital (NEDC) Risk

Capital Structure Decision: Type # 1.

Financial Risk:

The financial risk arises 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 its 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 earnings available to equity shareholders.

Capital Structure Decision: Type # 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 with the ratio of debt in its total capital. Higher the debt-equity ratio or the leverage, lower is the NEDC risk 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 of 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 a reach a balance (trade – off) between the financial risk and risk of non-employment of debt capital to increase its market value.

Degree of Leverage and Financial and NED Risks

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

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