Match List-I with List-II:
| List-I | List-II | ||
|---|---|---|---|
| (A) | Favourable financial leverage | (I) | The chance that a firm would fail to meet its payment obligations |
| (B) | Unfavourable financial leverage | (II) | The return on investment is lower than the cost of debt |
| (C) | Financial risk | (III) | It depends upon fixed operating costs such as rent, insurance premium and salaries |
| (D) | Business risk | (IV) | The return on investment is higher than the cost of debt |
Choose the correct answer from the options given below:
Answer & explanation
Correct answer: option 4
The correct answer is Option (4) → (A)-(IV), (B)-(II), (C)-(I), (D)-(III)
| List-I | List-II | Reason |
|---|---|---|
| (A) Favourable financial leverage | (IV) The return on investment is higher than the cost of debt | The firm earns more on its funds than it pays as interest. So extra debt raises the EPS. |
| (B) Unfavourable financial leverage | (II) The return on investment is lower than the cost of debt | The firm earns less on its funds than it pays as interest. So extra debt lowers the EPS. |
| (C) Financial risk | (I) The chance that a firm would fail to meet its payment obligations | Debt brings fixed charges such as interest and repayment. Financial risk is the chance of not meeting these payments. |
| (D) Business risk | (III) It depends upon fixed operating costs such as rent, insurance premium and salaries | Business risk is also called operating risk. Higher fixed operating costs mean higher business risk. |
Financial risk comes from how the firm raises its funds (the use of debt), while business risk comes from how it runs its operations (its fixed operating costs).
NCERT (2026-27 Edition): “EBIT-EPS Analysis … With higher use of debt, this difference between RoI and cost of debt increases the EPS. This is a situation of favourable financial leverage. …” “Example II In this example, the EPS of the company is falling with increased use of debt. It is because the Company’s rate of return on investment (RoI) is less than the cost of debt. … In such cases, the use of debt reduces the EPS. This is a situation of unfavourable financial leverage. Trading on Equity is clearly unadvisable in such a situation.” “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. Financial risk is the chance that a firm would fail to meet its payment obligations. …” “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. …” |