Introduction

This document outlines the capital structure risks and the role of debt to equity ratio in a
company’s growth. It also provides the perspectives of an investor in the market while investing
its money on debt versus equity. Discussion on the investment risks involved in a bond market
is also. Based on these topics, we will debate over the following :
1. Decrease in bond investments will lower the amount of risk a company is exposed to as
“a high debt-to-equity ratio is very risky”.
2. Decrease in equity investments will lower the amount of risk a company is exposed to as
“bond investments provide fixed cash flows and are therefore free of risk”.

Capital Structure
Capital structure represents how a company funds their overall operations and growth. It is a
combination of ​debt​ and ​equity​. Debt involves borrowing money which is due back to the
lenders that are mostly with interest expense. It comes in the form of bond issues or loans.

On the other hand, equity involves ownership rights in the company without the requirement to
pay back any investment. It comes in the form of stock.Capital structure is a mixture of a
company's long term debt, short term debt, common stock and preferred stock.

When analysing a company for investment, debt to equity(D/E) ratio is used in determining the
riskiness of a company’s borrowing practices. Greater the value of debt to equity ratio greater is
the contribution of debt in a company’s capital structure.

It has been seen that companies that use more debt than equity to finance their assets and
overall operations have a ​high leverage ratio and an aggressive​ ​capital structure. ​This
usually leads to higher growth rate but with greater risk.
On the other hand, a company that uses more equity than debt to finance their assets and
overall operations has a ​low leverage ratio and a conservative capital structure​. This usually
leads to lower growth rate but with lower risk.

A good debt to equity ratio is around ​1 to 1.5​(​src​). But, this value will vary depending on the
industry.
From the above explanation, we can clearly say that the statement “a high debt-to-equity ratio is
very risky” is valid. So, we can say that first person is correct.
Perspective on debt vs equity for issuing entity

Points in favour of equity funding​:

1. No obligation of the entity to repay the investors. Issuing entities don’t have to pay
interest on principal at a fixed interval.
2. If the issuing entity suffers from poor credit history or lacks a financial track record, then
it would be easier for them to raise capital via equity.
3. As equity makes the investors an owner of the issuing entity, it helps the business to
potentially benefit from their knowledge and their business knowledge.

Points in favour of debt funding​:

1. With debt funding, lenders have no say in how you manage your entity. All the decisions
are made by the company. This helps in fast decision making.
2. The amount paid in interest is tax deductible which effectively reduces the net obligation
of an entity.
3. As the principal and interest is known in advance, it is easier to budget and make
financial plans.
4. Raising capital in the equity market takes a lot of time. This robs the entity of a lot of time
that could have been used to run the entity.

Perspective on debt vs equity for investor

Points in favour of equity funding​ :

1. Investors are entitled to receive a dividend from the entity along with the capital gains
due to increase in market price of the share.
2. Liability of investors is limited to the investment made. If a company goes into losses, the
share is limited to investment made by the investor.
3. Investing in equity gives ownership in the entity to an investor and thereby it can
exercise control.
4. Ease of liquidity is better for equity sold on stock exchanges.

Points in favour of debt funding​ :

1. Stock market has higher volatility of returns than the bond market i.e. bond market is
safer for an investor than stock market.
 2. Investors have no or very little claim on a company's assets in case company defaults.
Whereas, with debt funding investors have full rights to their investment.
3. There is a fixed interest amount guaranteed over the principal. Hence, makes it a much
safer form of investment. 

Risk associated with Bond Investment

From the above comparisons, we can say that the ​second person’s opinion is valid​. But,
bond investments are not risk free​. Risks associated with bond investments are as follow :
1. Interest rate risk​ - ​Due to market reasons, an entity may require to increase its interest
rate in order to stay competitive in the market. This means an increasing amount of
interest payments and increased debt which might lead to bankruptcy.
2. Liquidity risk​ - ​This can happen if there are few or no buyers in the market but sellers
are activity engaged. This will lead to difficulty in converting the bond investment to cash.
This will make it difficult for the entity to raise capital in the bond market.
3. Systematic risk​ - ​Due to unpredictable market events, bond price can be affected. This
could lead to change in interest rates, lower bond price. This causes an increase in the
amount of interest payments which will lead to increased debt for the issuing entity.
4. Default risk​ - ​If an entity is perceived to have high default risk in the market, their bonds
will attract high interest rates and few to no market participants.

Conclusion
As part of this document, we understood about capital structure and its components. We
understood the comparison of equity vs debt from the perspective of an issuing entity and an
investor. We finally evaluated the risk associated with bond investment. Based on these topics,
we assessed statement 1 and 2 given in overview and described the reasoning behind them.

References
1. https://www.investopedia.com
2. https://corporatefinanceinstitute.com/resources/knowledge/finance/capital-structure-over
view
3. https://blog.hubspot.com/sales/debt-equity-ratio