The correct answer is option (3)- Capital Structure.
The mix between owners funds and borrowed funds is called Capital Structure.
Capital structure refers to the mix between owners and borrowed funds. 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.
OTHER OPTIONS
- Financial leverage- The proportion of debt in the overall capital is also called financial leverage. Financial leverage is computed as Debt/Equity or Debt / (D + E) when D is the Debt and E is the Equity. As the financial leverage increases, the cost of funds declines because of increased use of cheaper debt but the financial risk increases.
- Working capital- Working capital is the difference between currents assets and current liabilities. Short-term investment decisions (also called working capital decisions) are concerned with the decisions about the levels of cash, inventory and receivables. These decisions affect the day-to-day working of a business. These affect the liquidity as well as profitability of a business. Efficient cash management, inventory management and receivables management are essential ingredients of sound working capital management.
- Capital budgeting- A long-term investment decision is also called a Capital Budgeting decision. It involves committing the finance on a long term basis. For example, making investment in a new machine to replace an existing one or acquiring a new fixed asset or opening a new branch, etc. These decisions are very crucial for any business since they affect its earning capacity in the long run. The size of assets, profitability and competitiveness are all affected by capital budgeting decisions. Moreover, these decisions normally involve huge amounts of investment and are irreversible except at a huge cost. Therefore, once made, it is often almost impossible for a business to wriggle out of such decisions. Therefore, they need to be taken with utmost care.
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