Passage 1: Detrimental debt

On the basis of this passage, answer the questions from Q. No. 41 to Q. No. 45.

Even successful businesses have debt, but how much is too much? Learning how to manage debt is what can put you ahead. Taking on the right amount of debt can mean the difference between a business struggling to survive and one that can respond nimbly to changing economic or market conditions. A number of circumstances may justify acquiring debt. As a general rule, borrowing makes the most sense when you need to bolster cash flow or finance growth or expansion. But while debt can provide the leverage you need to grow, too much debt can strangle your business. So the question is: How much debt is too much?

A business that doesn't grow dies. You've got to grow, but you've got to grow within the financial constraints of your business. What is the ideal capital structure a business needs in its industry to remain viable? The higher the volatility (in your industry), the less debt you should have. The smaller the volatility, the more debt you can afford. Consider the capital structure of a growing company, NextGen Ltd.

Total Funds used Rs. 30 Lakh

Interest rate is 10% p.a.

Tax rate 30%

EBIT Rs. 4 Lakh

Nextgen Ltd. has an option to raise different amounts of debt:

Situation I : No Debt

Situation II : Rs. 10 Lakh Debt

Situation III : Rs. 20 Lakh Debt

Identify the correct statement.

Situation III attracts more financial risk than Situation II

The correct answer is option 1- Situation III attracts more financial risk than Situation II.

Total Funds: ₹30 Lakh
Interest Rate: 10% p.a.
Tax Rate: 30%
EBIT (Earnings Before Interest and Taxes): ₹4 Lakh

* Situation I: No Debt
Interest = 0
EBIT = ₹4,00,000
Tax = 30% of ₹4,00,000
      = ₹1,20,000
Net Income = ₹4,00,000 – ₹1,20,000
                  = ₹2,80,000

Financial risk = Low (no debt = no interest burden)

* Situation II: ₹10 Lakh Debt
Interest = 10% of ₹10,00,000
            = ₹1,00,000
EBIT = ₹4,00,000
EBT = ₹4,00,000 – ₹1,00,000
      = ₹3,00,000
Tax = 30% of ₹3,00,000
      = ₹90,000
Net Income = ₹3,00,000 – ₹90,000
                  = ₹2,10,000

Financial risk = Medium

 * Situation III: ₹20 Lakh Debt
Interest = 10% of ₹20,00,000
             = ₹2,00,000
EBT = ₹4,00,000 – ₹2,00,000
      = ₹2,00,000
Tax = 30% of ₹2,00,000
      = ₹60,000
Net Income = ₹2,00,000 – ₹60,000
                 = ₹1,40,000

Financial risk = High (due to higher interest burden)

As debt increases from ₹0 → ₹10L → ₹20L, interest obligations increase, and so does financial risk. So, situation III attracts more financial risk than Situation II.