Firm P can borrow at 8 per cent, while Firm Q, which is the same in all other respects, can borrow only at 12 per cent. Which factor affecting the choice of capital structure suggests that Firm P can employ more debt?
Answer & explanation
Correct answer: option 4
The correct answer is Option (4) → Cost of debt
Option (1) Tax rate — Incorrect. Interest is a deductible expense, so a higher tax rate makes debt cheaper after tax. The two firms differ only in the rate at which they can borrow.
Option (2) Cost of equity — Incorrect. Cost of equity is the return shareholders expect for the risk they carry. As debt rises, this return may go up, so it limits debt beyond a point. It does not show which firm borrows more cheaply.
Option (3) Floatation costs — Incorrect. Floatation costs are the costs of raising funds, such as the expenses of a public issue of shares or debentures. They are not the rate of interest on a loan.
Option (4) Cost of debt — Correct. A firm that can borrow at a lower rate can employ more debt. Firm P pays 8 per cent while Firm Q pays 12 per cent, so Firm P can carry more debt.
NCERT (2026-27 Edition): “5. Cost of debt: A firm’s ability to borrow at a lower rate increases its capacity to employ higher debt. Thus, more debt can be used if debt can be raised at a lower rate.” “6. Tax Rate: Since interest is a deductible expense, cost of debt is affected by the tax rate. The firms in our examples are borrowing @ 10%. Since the tax rate is 30%, the after tax cost of debt is only 7%. A higher tax rate, thus, makes debt relatively cheaper and increases its attraction vis-à-vis equity.” “7. Cost of Equity: Stock owners expect a rate of return from the equity which is commensurate with the risk they are assuming. When a company increases debt, the financial risk faced by the equity holders, increases. Consequently, their desired rate of return may increase. It is for this reason that a company can not use debt beyond a point. …” “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.” |