Given below are two statements: One is labelled as Assertion (A) and the other is labelled as Reason (R):

Assertion (A): Capital structure is determined within debt capacity of a company and it should not be exceeded.

Reason (R): Debt capacity of a company depends on its ability to generate cash flows. It should generate cash enough to pay lenders' fixed charges and principal sums.

In the light of the above statements, choose the most appropriate answer from the options given below:

The correct answer is - Both (A) and (R) are correct but (R) is NOT the correct explanation of (A)

Key Points

• Capital Structure
  • The capital structure refers to the mix of debt and equity financing used by a company.
  • It must be determined within the debt capacity of a company to ensure the firm can meet its debt obligations without excessive financial strain.
• Debt Capacity
  • Debt capacity depends on the company's ability to generate sufficient cash flows to meet its fixed obligations, such as interest payments and principal repayment.
  • While both statements are correct, Reason (R) explains why debt capacity is important, but it does not explain the reasoning behind the capital structure's limitation.

Additional Information

• Capital Structure and Debt Limits
  • The capital structure is designed to balance risk and return, ensuring that the company maintains enough flexibility in its finances without exceeding its debt capacity.
  • Exceeding debt capacity can lead to financial distress or bankruptcy if the company cannot meet its obligations.
• Reasoning for Debt Capacity
  • Debt capacity is impacted by a company's cash flow stability and its financial health.
  • The ability to repay debt is a critical factor in maintaining an optimal capital structure, ensuring long-term solvency.