Sigma Ltd. earns an RoI higher than its cost of debt. Its projected cash flows for next year will just cover its payments for normal operations, for new fixed assets and for interest and repayment of its present loans, with nothing left over. Should it raise more debt now?
Answer & explanation
Correct answer: option 2
The correct answer is Option (2) → No, as its cash flows must cover its fixed cash payment obligations and leave a sufficient buffer too.
Option (1) Yes, as its RoI is higher than its cost of debt, so trading on equity will raise its EPS. — Incorrect. A higher RoI does mean that trading on equity can raise the EPS. But new debt brings more interest and repayment every year. Sigma’s cash flows leave nothing over even now, so it cannot meet these extra outflows.
Option (2) No, as its cash flows must cover its fixed cash payment obligations and leave a sufficient buffer too. — Correct. Before borrowing, a firm must study its projected cash flows. They must cover the cash payments for normal operations, for fixed assets and for debt service. They must also leave a sufficient buffer. Sigma’s cash flows just cover its present payments, so more debt now is not safe.
Option (3) Yes, as its cash flows already cover all its present fixed cash payment obligations in full. — Incorrect. Covering the present obligations is not enough. Fresh debt adds new interest and repayment, and the cash flows must leave a buffer as well. Here they leave none.
Option (4) No, as more debt would cause a dilution of the management’s control over the business. — Incorrect. Debt normally does not dilute control. It is a public issue of equity that may reduce the management’s holding in the company.
NCERT (2026-27 Edition): “1. Cash Flow Position: Size of projected cash flows must be considered before borrowing. Cash flows must not only cover fixed cash payment obligations but there must be sufficient buffer also. It must be kept in mind that a company has cash payment obligations for (i) normal business operations; (ii) for investment in fixed assets; and (iii) for meeting the debt service commitments i.e., payment of interest and repayment of principal.” “4. Return on Investment (RoI): If the RoI of the company is higher, it can choose to use trading on equity to increase its EPS, i.e., its ability to use debt is greater. We have already observed in Example I that a firm can use more debt to increase its EPS. However, in Example II, use of higher debt is reducing the EPS. It is because the firm is earning an RoI of only 6.67% which lower than its cost of debt. In example I the RoI is 13.33%, and trading on equity is profitable. It shows that, RoI is an important determinant of the company’s ability to use Trading on equity and thus the capital structure.” “11. Control: Debt normally does not cause a dilution of control. A public issue of equity may reduce the managements’ holding in the company and make it vulnerable to takeover. This factor also influences the choice between debt and equity especially in companies in which the current holding of management is on a lower side.” |