Firms in an industry generally use a high proportion of debt. Arun Ltd. belongs to this industry, but its fixed operating costs are much higher than those of the other firms. How should Arun Ltd. use the industry norm in deciding its capital structure?
Answer & explanation
Correct answer: option 2
The correct answer is Option (2) → It should use less debt than the norm, as its higher business risk means it cannot afford the same financial risk.
Option (1) It should use more debt than the norm, as its higher fixed operating costs raise its capacity to use debt. — Incorrect. Higher fixed operating costs bring higher business risk. A firm with higher business risk has a lower capacity to use debt.
Option (2) It should use less debt than the norm, as its higher business risk means it cannot afford the same financial risk. — Correct. Business risk depends on fixed operating costs, so Arun Ltd. carries more business risk than its rivals. Total risk is business risk plus financial risk. So it cannot afford the same financial risk and should go in for low debt. Industry norms are a useful guide, but they should not be followed blindly.
Option (3) It should use more debt than the norm, as more use of cheaper debt lowers its overall cost of capital. — Incorrect. Debt is cheaper and can lower the overall cost of capital. But more debt also raises financial risk, and Arun Ltd. already has high business risk. So it should not add more debt.
Option (4) It should use less debt than the norm, as loans need more floatation expenditure than a public issue. — Incorrect. Less debt is right, but the reason is wrong. A public issue of shares and debentures needs considerable expenditure, while a loan from a financial institution may not cost so much.
NCERT (2026-27 Edition): “8. Floatation Costs: Process of raising resources also involves some cost. Public issue of shares and debentures requires considerable expenditure. Getting a loan from a financial institution may not cost so much. These considerations may also affect the choice between debt and equity and hence the capital structure.” “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. The total risk depends upon both the business risk and the financial risk. If a firm’s business risk is lower, its capacity to use debt is higher and vice-versa.” “14. Capital Structure of other Companies: A useful guideline in the capital structure planning is the debt-equity ratios of other companies in the same industry. There are usually some industry norms which may help. Care however must be taken that the company does not follow the industry norms blindly. For example, if the business risk of a firm is higher, it can not afford the same financial risk. It should go in for low debt. Thus, the management must know what the industry norms are, whether they are following them or deviating from them and adequate justification must be there in both cases.” |