Risks and Optimal Capital Structure Essay Example | Topics and Well Written Essays - 750 words

Risks and Optimal Capital Structure - Essay Example USA being a relatively efficient and informed market environment. Risks tend to be closely correlated with returns expected. The components of risks that are unique to US alone include: 1. Inflation risk._ inflation can provide a way to keep up with or stay ahead of inflation. It is defined as the rise in general levels of prices. During high period of inflation, there is a risk that the financial return of an investment will not keep pace with the inflation rate. It reduces the purchasing power, besides; this risk varies form one investment to the other. Small businesses can be seriously affected because this risk can not be insulated against such risk. 2. Market risk: _ the prices of stocks, bonds, mutual funds and various commodities and even services may fluctuate because of the behaviour of investors in the market place. As a result, economic growth is not as systematic and predictable as most investors might believe. Periods of rapid expansion are followed by periods of recession; it may be quite difficult to sell investments like real estate. Fluctuations in the market price for stocks and bonds may have nothing to do with the fundamental changes in the financial health of small businesses. Common causes of such fluctuations can be caused by political or social conditions. 3. 3. Interest rate risk _ this risk is associated with a fixed return investment in preferred stocks or government bonds. It is the result of changes in the interest rates in the economy. The value of these fixed investment securities and borrowed investment funds decreases when overall interest rates increase. 4. Global investment risk__Nowadays small businesses have become global hubs, as the world has become increasingly interconnected into a global village. Small traders keep their investments in foreign companies and other global players and this creates additional risks due to exchange rate in international currencies as exchange rates directly affect returns. 5. Business failure risk_ this is associated with the possibility of bad management, unsuccessful products, competition, or many other factors that can cause the business to be less profitable than originally anticipated. Lower profits would mean lower dividends or no dividends at all. Businesses can also close down due to bankruptcy too. Optimal capital structure means that businesses decide on what the best ratio is, between equity or owners capital and borrowed or debt should be. When such is carefully done, businesses should minimize borrowings as much as to avoid paying high interest on them. Incases from capital contributed from outsiders, corporations should first pay them (obligatorily) before paying themselves .this posses the question of maintaining an optimal capital structure to businesses regardless of their magnitude. REFERNCES 1. Financial management journal vol.33, 2004. 2. www.fma, 2007 3. Geoffrey A.Hirt and Stanley block, fundamentals of investment management 2003. 4. Kapoor Dlabay, personal finance 6th edition 2001. 5. Richard loth, www.investopedia.com, evaluating a company's capital structure, Oct