A company must choose that risk-return combination which maximises shareholders’ wealth. The debt-equity mix that achieves it is called:
Answer & explanation
Correct answer: option 4
The correct answer is Option (4) → the optimum capital structure
Option (1) favourable financial leverage — Incorrect. This is the case where the return on investment is higher than the cost of debt, so more debt raises the EPS. More debt also raises financial risk, so it does not on its own give the best mix.
Option (2) trading on equity — Incorrect. Trading on equity is the use of more cheaper debt to raise the profit of equity shareholders. Used recklessly, it adds financial risk.
Option (3) the debt-equity ratio — Incorrect. This ratio, debt ÷ equity, measures any capital structure. It shows the mix, whether good or bad.
Option (4) the optimum capital structure — Correct. More debt can raise the EPS, but it also raises financial risk. The optimum capital structure is the debt-equity mix with the best balance of risk and return, the one that maximises shareholders’ wealth.
NCERT (2026-27 Edition): “Capital Structure … 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. …” “Example II … Ideally, a company must choose that risk-return combination which maximises shareholders’ wealth. The debt-equity mix that achieves it, is the optimum capital structure.” |