There are two statements marked as Assertion (A) and Reason (R). Mark your answer as per the options given below.
Assertion (A): If the Debt to Equity Ratio is 4:2, the purchase of fixed assets of ₹100000 by taking long-term borrowing from the bank will increase the ratio.
Reason (R): Machinery is a fixed asset and its purchase, therefore, does not affect Debt and Shareholder's Funds but it is purchased on Long-term Borrowing from the bank which increases Debt but does not affect Shareholders' Funds. Hence, the Debt to Equity Ratio will increase.
Answer & explanation
Correct answer: option 1
The correct answer is option 1- Both, Assertion (A) and Reason (R) are correct and Reason (R) is the correct explanation of Assertion (A).
Assertion (A): If the Debt to Equity Ratio is 4:2, the purchase of fixed assets of ₹1,00,000 by taking long-term borrowing from the bank will increase the ratio. THIS IS TRUE. Let us do it with an example-
Let us assume debt = ₹4,00,000 and equity = ₹2,00,000
Machinery purchases make debt to increase by ₹1,00,000 as it is purchased by long term borrowing.
There is no effect on equity.
So,debt- equity ratio = 5,00,000/ 2,00,000 = 5:2
Reason (R): Machinery is a fixed asset and its purchase, therefore, does not affect Debt and Shareholder's Funds but it is on Long-term Borrowing from the bank which increases Debt but does not affect Shareholders' Funds. Hence, the Debt to Equity Ratio will increase. THIS IS TRUE.