The equity shareholders of Nikhil Ltd. now expect a higher rate of return from their investment than they did two years ago. Which of the following changes in the company is the most likely reason?
Answer & explanation
Correct answer: option 2
The correct answer is Option (2) → The company has raised the share of debt in its capital structure.
Option (1) The rate of tax on the company’s income has gone up. — Incorrect. Interest is a deductible expense, so a higher tax rate makes debt relatively cheaper. It does not add to the risk carried by equity holders.
Option (2) The company has raised the share of debt in its capital structure. — Correct. Equity holders expect a return in line with the risk they carry. More debt raises the financial risk faced by equity holders, so their desired rate of return goes up. This is the cost of equity factor.
Option (3) The company has cut down its fixed operating costs. — Incorrect. Lower fixed operating costs mean lower business risk. Equity holders would then have less reason to ask for more.
Option (4) The company has kept some of its borrowing power unused. — Incorrect. Keeping some borrowing power unused is flexibility. The company carries less debt than it could, so the risk for equity holders is lower.
NCERT (2026-27 Edition): “6. Tax Rate: Since interest is a deductible expense, cost of debt is affected by the tax rate. The firms in our examples are borrowing @ 10%. Since the tax rate is 30%, the after tax cost of debt is only 7%. A higher tax rate, thus, makes debt relatively cheaper and increases its attraction vis-à-vis equity.” “7. Cost of Equity: Stock owners expect a rate of return from the equity which is commensurate with the risk they are assuming. When a company increases debt, the financial risk faced by the equity holders, increases. Consequently, their desired rate of return may increase. It is for this reason that a company can not use debt beyond a point. If debt is used beyond that point, cost of equity may go up sharply and share price may decrease inspite of increased EPS. Consequently, for maximisation of shareholders’ wealth, debt can be used only upto a level.” “9. Risk Consideration: As discussed earlier, use of debt increases the financial risk of a business. Financial risk refers to a position when a company is unable to meet its fixed financial charges namely interest payment, preference dividend and repayment obligations. Apart from the financial risk, every business has some operating risk (also called business risk). Business risk depends upon fixed operating costs. Higher fixed operating costs result in higher business risk and vice-versa. The total risk depends upon both the business risk and the financial risk. If a firm’s business risk is lower, its capacity to use debt is higher and vice-versa.” “10. Flexibility: If a firm uses its debt potential to the full, it loses flexibility to issue further debt. To maintain flexibility, it must maintain some borrowing power to take care of unforeseen circumstances.” |