_________ of a company affects both the profitability and the financial risk.

Capital Structure

The correct answer is option (2)- Capital Structure.

Capital Structure of a company affects both the profitability and the financial risk.

Capital structure refers to the mix between owners and borrowed funds. These shall be referred as equity and debt in the subsequent text. It can be calculated as debt-equity ratio i.e., Debt/Equity  or as the proportion of debt out of the total capital i.e., Debt/(Debt + Equity) . Debt and equity differ significantly in their cost and riskiness for the firm. The cost of debt is lower than the cost of equity for a firm because the lender’s risk is lower than the equity shareholder’s risk, since the lender earns an assured return and repayment of capital and, therefore, they should require a lower rate of return. Additionally, interest paid on debt is a deductible expense for computation of tax liability whereas dividends are paid out of after-tax profit. Increased use of debt, therefore is likely to lower the over-all cost of capital of the firm provided that the cost of equity remains unaffected. Debt is cheaper but is more risky for a business because the 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 a business. As a result, increased use of debt increases the financial risk of a company. Financial risk is the chance that a firm would fail to meet its payment obligations. Capital structure of a company, 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. In other words, all decisions relating to capital structure should emphasise on increasing the shareholders’ wealth. The proportion of debt in the overall capital is also called financial leverage.