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Home Questions UTWK7KG2DR
Target Exam

CUET

Subject

Business Studies

Chapter

Financial Management

Question:
Read the Paragraph given below carefully and answer the following 5 questions. (Q No 1)
Sunrises Ltd. dealing in readymade garments, is planning to expand its business operations in order to cater to international market. For this purpose the company needs additional Rs.80,00,000 for replacing machines with modern machinery of higher production capacity. It involves committing the finance on a long term basis. These decisions are very crucial for any business since they affect its earning capacity in the long run. The company wishes to raise the required funds by issuing debentures. The debt can be issued at an estimated cost of 10%. The EBIT for the previous year of the company was Rs. 8,00,000 and total capital investment was Rs. 1,00,00,000. Instead of issuing 10% Debenture the Company can issue Equity Shares for raising the fund. The financial manager of the company would normally opt for a source which is the cheapest.
"Assertion: Debt is cheaper but is more risky for a business.
Reasoning: The payment of interest and the return of principal is obligatory for the business. Any default in meeting these commitments may force the business to go into liquidation."
Options:
Both Assertion (A) and reasoning (R) are correct and R is the correct explanation of A.
Both Assertion (A) and reasoning (R) are correct and but R is not the correct explanation of A.
Assertion (A) is true but Reasoning (R) is not correct.
Assertion (A) is not true but Reasoning (R) is correct.
Correct Answer:
Both Assertion (A) and reasoning (R) are correct and R is the correct explanation of A.
Explanation:
The firm gets an income tax benefit on the interest component that is paid to lender. Therefore, the net taxable income of the company is reduced to the extent of the interest paid. All other sources do not provide any such benefit and hence ,it is considered as a cheaper source of finance .As a business takes on more and more debt, its probability of defaulting on its debt increases. This is because more debt equals higher interest payments.
The payment of interest and the return of principal is obligatory for the business. Any default in meeting these commitments may force the business to go into liquidation."

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