Read the passage and answer the following questions:

XYZ Textiles Ltd., a mid-sized manufacturer of apparel, is facing several financial management challenges. The company needs to optimize its working capital management due to increasing inventory levels and longer accounts receivable cycles. The current ratio is 1.4, but the quick ratio is low at 0.7, indicating potential liquidity issues.

XYZ Textiles is considering expanding its operations by purchasing new machinery, costing 10 million dollar. The project is expected to generate cash flows of $2 million annually for 7 years. The management is evaluating the project using capital budgeting techniques such as NPV and IRR. The company's cost of capital (WACC) is 9%, and the calculated NPV is positive, while the IRR is 12%, suggesting the project is viable.

The company's capital structure consists of 60% equity and 40% debt. With interest rates rising, the management is weighing whether to increase debt financing to fund the expansion or issue additional equity, which could dilute shareholder control. They are also concerned about maintaining an optimal mix to minimize the weighted average cost of capital (WACC).

Finally, the company's dividend policy has been a consistent payout of 30% of net income. With expansion plans underway, the management debates whether to cut dividends to retain more earnings for reinvestment or maintain the payout to appease shareholders.

Which of the following is an advantage of debt financing?

Tax deductibility of interest payments

The correct answer is option 4- Tax deductibility of interest payments.

Tax deductibility of interest payments is an advantage of debt financing.

Debt financing involves borrowing money (e.g., through loans or bonds) that must be repaid with interest. One key advantage of this method is that the interest payments on debt are tax-deductible, which can reduce the company’s taxable income and thus its tax liability.

The cost of each type of finance has to be estimated. Some sources may be cheaper than others. For example, debt is considered to be the cheapest of all the sources, tax deductibility of interest makes it still cheaper. Associated risk is also different for each source, e.g., it is necessary to pay interest on debt and redeem the principal amount on maturity. There is no such compulsion to pay any dividend on equity shares. Thus, there is some amount of financial risk in debt financing. The overall financial risk depends upon the proportion of debt in the total capital. The fund raising exercise also costs something. This cost is called floatation cost. It also must be considered while evaluating different sources. Financing decision is, thus, concerned with the decisions about how much to be raised from which source. This decision determines the overall cost of capital and the financial risk of the enterprise.

OTHER OPTIONS

• High flexibility in dividend payments – This relates to equity financing, not debt. Debt requires fixed interest payments, regardless of profitability.
• Increased control for existing shareholders – Debt does not dilute ownership, so this is true relative to equity, but not an advantage unique to debt; it's more of a consequence. 
• Lower financial risk – Debt actually increases financial risk because it creates fixed obligations, which can lead to insolvency if cash flow is insufficient.