Question

Explain the following factors affecting the choice of capital structure of a company :

(i) Tax rate

(ii) Risk consideration

Hint:

Interest saves tax, so a high tax rate favours debt. Debt also brings fixed payments, so higher risk favours less debt.

Answer 1

Step 1: Meaning of capital structure:
Capital structure is the mix of debt and equity that a company uses to finance its operations. The company picks the mix that gives the best balance of cost and risk.
We now see how the tax rate and risk consideration affect this choice.

Step 2: Factor (i): Tax rate:
Interest paid on debt is a deductible expense, so it reduces the profit on which tax is paid. Dividend on shares is paid after tax and gets no such relief.
When the tax rate is high, debt becomes cheaper after tax. So a company prefers more debt in its capital structure.

Step 3: Example for tax rate:
Say a company pays Rs. 1,00,000 as interest and the tax rate is 30 percent. It saves Rs. 30,000 in tax, so the real cost of this debt is only Rs. 70,000.
A low tax rate gives little saving, so the company may lean more on equity.

Step 4: Factor (ii): Risk consideration:
Debt brings financial risk. Interest must be paid and the loan must be repaid, whether the company earns profit or not. If it fails, lenders can take legal action.
Equity carries no fixed payment, so it has no such risk. A company with unstable earnings therefore keeps debt low, and a company with stable earnings can take more debt.

Step 5: Link to business risk:
Business risk comes from changes in sales and costs. When business risk is already high, adding debt makes the total risk too heavy.
So the company balances the two kinds of risk while choosing its capital structure.

Final Answer:
A high tax rate favours more debt because interest saves tax. A high risk level favours less debt because fixed payments become hard to meet.