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

What does the term "Capital Structure" imply?

It indicates a mix between debt and equity

The correct answer is option 4- It indicates a mix between debt and equity.

Capital structure refers to the mix between owners and borrowed funds. These shall be referred as equity and debt in the subsequent text. It can be calculated as debt-equity ratio i.e., Debt/Equity or as the proportion of debt out of the total capital i.e., Debt/(Debt + Equity). Debt and equity differ significantly in their cost and riskiness for the firm. The cost of debt is lower than the cost of equity for a firm because the lender’s risk is lower than the equity shareholder’s risk, since the lender earns an assured return and repayment of capital and, therefore, they should require a lower rate of return. Additionally, interest paid on debt is a deductible expense for computation of tax liability whereas dividends are paid out of after-tax profit. Increased use of debt, therefore is likely to lower the over-all cost of capital of the firm provided that the cost of equity remains unaffected.