Read the following text and answer the following questions on the basis of the same.
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.
Answer & explanation
Correct answer: option 2
The correct answer is Option (2) → Tax Rate
Option (1) Inflation — Incorrect. Inflation is a general rise in prices. It does not explain why debt is the cheapest source here.
Option (2) Tax Rate — Correct. Interest on debt is a tax-deductible expense, as the passage says. The tax saved lowers the real cost of debt. The higher the tax rate, the more tax is saved, and the cheaper debt becomes compared with equity, whose dividend saves no tax.
Option (3) Growth Prospects — Incorrect. Growth prospects affect how much money a firm needs and how much profit it keeps back. They do not lower the cost of debt.
Option (4) Financing Alternatives — Incorrect. This only refers to the choices of finance open to the firm. It says nothing about why debt is cheaper.
NCERT (2026-27 Edition): “Financing Decision … The cost of each type of finance has to be estimated. Some sources may be cheaper than others. For example, debt is considered to be the cheapest of all the sources, tax deductibility of interest makes it still cheaper. …” “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.” |