Read the following information and answer the question.
XYZ Ltd. needs total funds of Rs. 50 lakh. It is comparing two ways of raising them.
| Total funds used | Rs. 50 lakh |
| Face value of each equity share | Rs. 10 |
| Rate of interest on debt | 10% p.a. |
| Tax rate | 20% |
| EBIT | Rs. 5 lakh |
| Debt in Situation I | Nil |
| Debt in Situation II | Rs. 15 lakh |
The rest of the funds is raised by issuing equity shares.
In which situation is the financial risk of XYZ Ltd. higher, and why?
Answer & explanation
Correct answer: option 2
The correct answer is Option (2) → Situation II, because interest and repayment are obligatory
Option (1) Situation I, because the dividend on equity is obligatory — Incorrect. There is no compulsion to pay a dividend on equity. Situation I has no debt, so it has no fixed financial charges at all.
Option (2) Situation II, because interest and repayment are obligatory — Correct. Financial risk is the chance that a firm fails to meet its payment obligations. In Situation II the Rs. 15 lakh debt brings interest every year and repayment later. Both must be paid, and a default may even force the business into liquidation.
Option (3) Situation II, because its earnings per share are lower — Incorrect. The EPS is Rs. 0.80 in both situations. Financial risk comes from the fixed payment obligations of debt.
Option (4) Neither, because the RoI is the same in both situations — Incorrect. The RoI is the same because EBIT and total funds are the same in both situations. Financial risk depends on the proportion of debt, and only Situation II has debt.
NCERT (2026-27 Edition): “Capital Structure … Debt is cheaper but is more risky for a business because the payment of interest and the return of principal is obligatory for the business. Any default in meeting these commitments may force the business to go into liquidation. There is no such compulsion in case of equity, which is therefore, considered riskless for the business. Higher use of debt increases the fixed financial charges of a business. As a result, increased use of debt increases the financial risk of a company. Financial risk is the chance that a firm would fail to meet its payment obligations. …” |