Skip to main contentSkip to solution

Charvi, after acquiring a degree in Hotel Management and Business Administration took over her family food processing company of manufacturing pickles, jams and squashes. The business was established by her great grandmother and was doing reasonably well. However, the fixed operating costs of the business were high and the cash flow position was weak. She wanted to undertake modernization of the existing business to introduce the latest manufacturing processes and diversify into the market of chocolates and candies. She was very enthusiastic and approached a Financial Consultant, who told her that approximately Rs. 50 lakhs would be required for undertaking the modernization and expansion programme. The Financial Consultant advised her about the judicious mix of equity (40%) and Debt (60%). He also suggested her to take loan from Financial Institution as the cost of raising funds from Financial Institutions is low. Though this will increase the financial risk, but will also raise the return to equity shareholders. He also apprised her that issue of debt will not dilute the control of equity shareholders. At the same time, the interest on loan is a tax deductible expense for computation of tax liability. After due deliberations with the Financial Consultant, Charvi decided to raise funds from a Financial Institution.

"Debt is considered to be the cheapest of all the sources". Identify the factor which supports this source of finance.

Solution

✅ Correct Option: 2

Interest on debt is a tax deductible expense while dividend is paid out of after-tax profits. A higher tax rate therefore reduces the after-tax cost of debt, making debt the cheapest source of finance. Hence the factor supporting debt is the tax rate.

Keyboard Shortcuts

  • Left arrow: Previous question
  • Right arrow: Next question
  • S key: Jump to solution
  • Q key: Jump to question