Fundamentals of Financial Management, Third Edition

14.5 FEATURES OF A SOUND CAPITAL STRUCTURE

The preceding section has thrown a good deal of light on the attainment of an optimal capital structure. Based on this discussion, the features of a sound capital structure can be delineated as follows:

1. Perfect trade-off between risk and return;
2. Minimum cost of capital;
3. Sufficiency of cash flow to service debt;
4. Maintenance of industry norm;
5. Flexibility.

Leverage raises the return on equity and thereby the value of the firm. However, at the same time, it tends to inflate the debt to an unmanageable extent, increasing in turn the financial risk to be borne by the shareholders. Thus a sound capital structure permits leverage only to that extent that represents a perfect trade-off between risk and return. ...