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XYZ Textiles Ltd., a mid-sized manufacturer of apparel, is facing several financial management challenges. The company needs to optimize its working capital management due to increasing inventory levels and longer accounts receivable cycles. The current ratio is 1.4, but the quick ratio is low at 0.7, indicating potential liquidity issues.

XYZ Textiles is considering expanding its operations by purchasing new machinery, costing 10million.Theprojectisexpectedtogeneratecashflowsof10 million. The project is expected to generate cash flows of 2 million annually for 7 years. The management is evaluating the project using capital budgeting techniques such as NPV and IRR. The company's cost of capital (WACC) is 9%, and the calculated NPV is positive, while the IRR is 12%, suggesting the project is viable.

The company's capital structure consists of 60% equity and 40% debt. With interest rates rising, the management is weighing whether to increase debt financing to fund the expansion or issue additional equity, which could dilute shareholder control. They are also concerned about maintaining an optimal mix to minimize the weighted average cost of capital (WACC).

Finally, the company's dividend policy has been a consistent payout of 30% of net income. With expansion plans underway, the management debates whether to cut dividends to retain more earnings for reinvestment or maintain the payout to appease shareholders.

Which of the following is an advantage of debt financing?

Solution

✅ Correct Option: 4

Option 1 -> High flexibility in dividend payments: This relates to equity, not debt. Debt requires fixed interest payments, reducing flexibility.

Option 2 -> Increased control for existing shareholders: While debt doesn't dilute ownership, this is a secondary benefit, not the primary advantage.

Option 3 -> Lower financial risk: Incorrect. Debt actually increases financial risk due to mandatory interest and principal repayment obligations.

Option 4 -> Tax deductibility of interest payments: Interest on debt is tax-deductible, reducing the effective cost of borrowing and providing a tax shield benefit.


Hence, Option 4: Tax deductibility of interest payments -> Interest payments on debt are treated as business expenses and are tax-deductible, which lowers the company's taxable income and reduces the after-tax cost of debt financing. This tax shield is a primary advantage that makes debt financing attractive compared to equity financing -> correct

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