Raj Ltd. has kept raising more debt. Its earnings per share have risen, but its share price has started to fall.
Which factor affecting the choice of capital structure explains why the company should not use debt beyond a point?
Answer & explanation
Correct answer: option 2
The correct answer is Option (2) → Cost of equity
Option (1) Return on investment — Incorrect. A high RoI lets a company use debt to raise its EPS. That explains the rising EPS, not the falling share price.
Option (2) Cost of equity — Correct. More debt raises the financial risk borne by equity holders, so they expect a higher return. Beyond a point the cost of equity rises sharply and the share price may fall even though EPS has risen, as at Raj Ltd. So debt can be used only up to a level.
Option (3) Interest coverage ratio — Incorrect. This ratio shows how many times EBIT covers the interest. It tells the risk of missing interest payments, not why the share price falls.
Option (4) Flexibility — Incorrect. Flexibility means keeping some borrowing power in reserve for unforeseen needs. It is not about shareholders' return and the share price.
NCERT (2026-27 Edition): “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. If debt is used beyond that point, cost of equity may go up sharply and share price may decrease inspite of increased EPS. Consequently, for maximisation of shareholders’ wealth, debt can be used only upto a level.” |