(a) Explain the concept of optimal capital structure. How does a company decide on the right mix of debt and equity? 6+4=10 (b)…

(a)

Optimal capital structure is the debt-equity mix that minimises weighted average cost of capital (WACC) and maximises firm value. It is an equilibrium where the marginal benefit of debt equals its marginal cost. Debt is cheaper because interest is tax deductible, creating a tax shield; but excessive debt raises bankruptcy risk, agency costs and financial distress. Trade-off theory captures this: a firm adds debt while the tax shield outweighs expected insolvency costs, then stops. In practice, a company uses EBIT-EPS analysis, checks whether trading on equity raises EPS and share price, and weighs business risk, financial flexibility, control dilution and growth opportunities. High business risk or volatile earnings calls for less debt; stable cash flows allow more leverage. Causally, more debt lowers WACC through the tax shield, but if risk rises, cost of equity and distress costs increase, reducing value. Hence the right mix is where incremental debt no longer adds value.

(b)

The Miller-Orr model manages cash for uncertain cash flows. It assumes a two-asset firm holding cash and marketable securities, a fixed cost b per transfer, same for buying and selling, and net cash flows following a random walk. The firm sets a lower limit L, usually 0, and an upper limit H. When cash falls to L, it sells securities to restore the return point z; when cash rises to H, it buys securities to bring cash back to z. The optimal return point is z = ∛(3bσ²/(4i)) + L, where σ² is variance of daily net cash flows and i is the opportunity cost rate. The upper limit is H = 3z − 2L. The average cash balance is (4z − L)/3. The model balances transaction costs against opportunity costs: a wider spread reduces transfers but raises idle cash, while a narrower spread lowers idle cash but increases transactions. It suits unpredictable cash flows, not strongly seasonal or trended flows.

(c)

In India, the money market is the short-term segment, dealing in instruments with maturity of one year or less. It provides liquidity to banks, corporations and government through treasury bills, call money, commercial paper, certificates of deposit, repo and reverse repo. Participants include RBI, scheduled commercial banks, corporates, mutual funds and primary dealers. The capital market is the long-term segment, with shares, debentures, bonds, equity funds and government securities maturing beyond one year. It mobilises long-term savings for companies and government through NSE and BSE, with participants including corporate issuers, foreign portfolio investors (FPIs), retail investors and domestic institutions. Regulators differ: RBI mainly oversees money-market operations and short-term instruments, while SEBI regulates capital markets and protects investors. Causally, money markets manage day-to-day liquidity and interest-rate transmission, whereas capital markets determine long-term cost of capital and asset prices. Money markets are highly liquid and lower-risk; capital markets are deeper, more volatile and expose investors to longer-term business and interest-rate risk.

(d)

Dividend policy decides how much of earnings a company distributes and how much it retains. It links profitability, investment needs and shareholder expectations. A stable dividend policy pays a fixed or slowly rising dividend, giving confidence but possibly straining cash in weak years. A constant payout ratio pays a fixed percentage of earnings, aligning dividends with performance but making payouts volatile. A residual dividend policy first funds positive-NPV projects and pays only surplus earnings, preserving flexibility but producing irregular dividends. A hybrid policy combines stability with payout discipline. Lintner’s partial adjustment model explains that firms adjust dividends gradually toward a target payout, avoiding abrupt changes. The policy is contested: Walter and Gordon argue dividends matter because they affect risk and growth, while Modigliani-Miller argue, in perfect markets, dividends are irrelevant to value. Practically, it signals confidence and shapes demand.

(e)

Financial services channel savings into investment and provide payment, risk management, advisory and credit facilities. They include banking, insurance, securities, asset management and credit information. Credit rating is an opinion on the creditworthiness of a debt instrument or issuer, assessing the likelihood of timely payment of principal and interest. In India, its importance grew after 1991 reforms when market-based borrowing expanded and investors needed independent signals. SEBI (Credit Rating Agencies) Regulations, 1999, brought CRAs under regulation, while registered agencies such as CRISIL, ICRA, CARE, India Ratings and Acuité provide ratings to bonds, debentures, commercial paper and infrastructure projects. The causal mechanism is that ratings reduce information asymmetry: investors can price default risk more accurately, issuers with strong ratings borrow at lower cost, and weaker issuers face higher spreads. Ratings also protect retail investors, support institutional allocation, and deepen the bond market. Yet ratings are opinions, not guarantees.