The management of Kavya Ltd. holds only a small part of its equity shares. The company now plans a large public issue of equity shares. What is the main risk in this plan?
Answer & explanation
Correct answer: option 2
The correct answer is Option (2) → The company may become vulnerable to a takeover by outsiders.
Option (1) The company may be unable to meet its fixed financial charges. — Incorrect. Fixed financial charges are interest, preference dividend and repayment. The risk of not meeting them comes from debt, and an equity issue adds no such charge.
Option (2) The company may become vulnerable to a takeover by outsiders. — Correct. A public issue of equity brings in many new shareholders. The management’s holding falls further, so outsiders can buy enough shares to take control.
Option (3) The company may lose its flexibility to borrow in future. — Incorrect. A firm loses flexibility when it uses its debt potential to the full. An equity issue leaves its borrowing power unused.
Option (4) The company may face higher business risk in its operations. — Incorrect. Business risk depends upon fixed operating costs such as rent and salaries. The way capital is raised does not change these costs.
NCERT (2026-27 Edition): “11. Control: Debt normally does not cause a dilution of control. A public issue of equity may reduce the managements’ holding in the company and make it vulnerable to takeover. This factor also influences the choice between debt and equity especially in companies in which the current holding of management is on a lower side.” “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. …” “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.” |