Capital Structure & Risk-Return Tradeoff


Compiled by Jeemit Shah

Capital structure is the particular combination of debt and equity used by a company to finance its overall operations and growth.

Equity capital arises from ownership shares in a company and claims to its future cash flows and profits. Debt comes in the form of bond issues or loans, while equity may come in the form of common stock, preferred stock, or retained earnings. Short-term debt is also considered to be part of the capital structure.

Both debt and equity can be found on the balance sheet. Company assets, also listed on the balance sheet, are purchased with debt or equity. Capital structure can be a mixture of a company’s long-term debt, short-term debt, common stock, and preferred stock. A company’s proportion of short-term debt versus long-term debt is considered when analyzing its capital structure.

When analysts refer to capital structure, they are most likely referring to a firm’s debt-to-equity (D/E) ratio, which provides insight into how risky a company’s borrowing practices are. Usually, a company that is heavily financed by debt has a more aggressive capital structure and therefore poses a greater risk to investors. This risk, however, may be the primary source of the firm’s growth.

Risk Return Tradeoff

The risk-return tradeoff states that the potential return rises with an increase in risk. Using this principle, individuals associate low levels of uncertainty with low potential returns, and high levels of uncertainty or risk with high potential returns. According to the risk-return tradeoff, invested money can render higher profits only if the investor will accept a higher possibility of losses.

The trading principle that links high risk with high reward. The appropriate risk-return tradeoff depends on a variety of factors including an investor’s risk tolerance, the investor’s years to retirement and the potential to replace lost funds. Time also plays an essential role in determining a portfolio with the appropriate levels of risk and reward. For example, if an investor has the ability to invest in equities over the long term, that provides the investor with the potential to recover from the risks of bear markets and participate in bull markets, while if an investor can only invest in a short time frame, the same equities have a higher risk proposition.

Investors use the technique as one of the essential components of each investment decision, as well as to assess their portfolios as a whole. At the portfolio level, the risk-return tradeoff can include assessments of the concentration or the diversity of holdings and whether the mix presents too much risk or a lower-than-desired potential for returns.

When an investor considers high-risk-high-return investments, the investor can apply the risk-return tradeoff to the vehicle on a singular basis as well as within the context of the portfolio as a whole.

For example, a penny stock position may have a high risk on a singular basis, but if it is the only position of its kind in a larger portfolio, the risk incurred by holding the stock is minimal.

That said, the risk-return tradeoff also exists at the portfolio level. For example, a portfolio composed of all equities presents both higher risk and higher potential returns.

Generally, the risk and return trade-off are calculated with the help of a few metrics. In the case of mutual funds, investors determine the trade-off with the help of these metrics:

  • Alpha -Alpha measures the risk-adjusted returns of a mutual fund scheme against its underlying benchmark. If a mutual fund follows Nifty 50, the risk-adjusted returns of the fund above or below the performance of the benchmark are considered alpha. For instance, a negative alpha of 1 means that the mutual fund underperformed in comparison to its benchmark by 1%. A positive alpha indicates better performance than the benchmark. The higher the alpha is, the higher is the potential returns.
  • Beta – Beta measures the volatility of the fund according to the benchmark. A higher or positive beta means that the fund is more volatile as compared to its benchmark. Funds have lower or negative beta if their volatility is lower than the benchmark. Funds with lower betas are highly recommended to new investors as they are less volatile. But less volatility often leads to lower returns as compared to a fund with a higher beta. However, higher beta does not guarantee higher returns.
  • Sharpe Ratio – Sharpe Ratio is used for analyzing the risk-adjusted returns potential of a mutual fund scheme. In other words, it measures the potential returns of a scheme against each unit of risk the scheme has undertaken. So, the Sharpe Ratio of 1 means that the returns potential of a fund is higher than what is expected for an investment at a particular risk level. If the ratio is below 1, it signifies that the potential return of the fund is lower than the risk carried by the fund.
  • Standard Deviation – Standard deviation measures the individual returns of an investment over time against its average return for the same period. So, a higher standard deviation means that the fund is volatile and carries a higher level of risk as compared to a fund with a lower standard deviation. The standard deviation of a fund is compared against the standard deviation of funds from the same category to evaluate volatility and risk.