Which of the following would increase a company's capacity to use more debt in its capital structure?
Answer & explanation
Correct answer: option 2
The correct answer is Option (2) → Its ability to raise debt at a lower rate of interest than before.
Option (1) A rise in its fixed operating costs, such as rent and insurance premium. — Incorrect. Fixed operating costs decide business risk: the higher these costs, the higher the business risk. When business risk is higher, the capacity to use debt is lower, so such a firm should keep its fixed financing costs low.
Option (2) Its ability to raise debt at a lower rate of interest than before. — Correct. Debt raised at a lower rate is cheaper to service. So a firm’s ability to borrow at a lower rate increases its capacity to employ more debt.
Option (3) A fall in the tax rate applicable to the company. — Incorrect. Interest is a deductible expense, so tax lowers the real cost of debt. A higher tax rate makes debt relatively cheaper. A fall in the tax rate works the other way: debt becomes costlier after tax and less attractive.
Option (4) Full use of its present debt potential. — Incorrect. A firm that uses its debt potential to the full loses flexibility to issue further debt. To stay flexible, it must keep some borrowing power for unforeseen needs.
NCERT (2026-27 Edition): “5. Cost of debt: A firm’s ability to borrow at a lower rate increases its capacity to employ higher debt. Thus, more debt can be used if debt can be raised at a lower rate.” “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.” “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.” |