Which of the following statements about the factors affecting the choice of capital structure is NOT correct?
Answer & explanation
Correct answer: option 3
The correct answer is Option (3) → Capital structure of other companies: a firm with higher business risk should follow its industry’s debt-equity ratio.
Option (1) Flexibility: to take care of unforeseen circumstances, a firm must maintain some borrowing power. — True. A firm that uses its full debt capacity cannot borrow more later. So it keeps some borrowing power in reserve.
Option (2) Regulatory framework: a public issue of shares and debentures has to be made under the guidelines of SEBI. — True. Every company works within the law. A public issue must follow SEBI guidelines, and this can affect the choice of source.
Option (3) Capital structure of other companies: a firm with higher business risk should follow its industry’s debt-equity ratio. — False. Industry debt-equity ratios are a useful guide, but they must not be followed blindly. A firm with higher business risk cannot afford the same financial risk, so it should go in for low debt.
Option (4) Floatation costs: getting a loan from a financial institution may not cost as much as a public issue of shares. — True. A public issue of shares needs considerable expenditure on raising the money. A loan from a financial institution usually costs less to arrange.
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.” “10. Flexibility: If a firm uses its debt potential to the full, it loses flexibility to issue further debt. To maintain flexibility, it must maintain some borrowing power to take care of unforeseen circumstances.” “12. Regulatory Framework: Every company operates within a regulatory framework provided by the law e.g., public issue of shares and debentures have to be made under SEBI guidelines. …” “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.” |