The optimal combination of various sources of funds for a business is called:

Capital structure

The correct answer is option 1- Capital structure.

The optimal combination of various sources of funds for a business is called Capital structure.

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.