Debt is cheaper but more risky for a business, as the payment of interest and the return of principal are obligatory. Any default in meeting these commitments may __________.
Answer & explanation
Correct answer: option 2
The correct answer is Option (2) → force the business to go into liquidation
Option (1) turn its financial leverage from favourable to unfavourable — Incorrect. Leverage turns unfavourable when the return on investment falls below the cost of debt. That is about earnings, and it can happen even when every payment is made on time.
Option (2) force the business to go into liquidation — Correct. Interest and the return of principal must be paid, whatever the profit. If the business fails to pay, it may be forced into liquidation, that is, closed down and its assets sold. Equity carries no such compulsion.
Option (3) raise the fixed operating costs of the business — Incorrect. Fixed operating costs are costs such as rent, insurance premium and salaries. They come from running the business, and a default on debt does not add to them.
Option (4) dilute the management’s control over the business — Incorrect. Debt normally does not dilute control. It is a public issue of equity that may cut the management’s holding.
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. …” “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.” |