Given below are two statements:
Assertion (A): For maximisation of shareholders’ wealth, a company can use debt only up to a level.
Reason (R): When a company increases debt, the financial risk faced by the equity holders increases, so their desired rate of return may increase.
In the light of the above statements, choose the correct answer from the options given below:
Answer & explanation
Correct answer: option 1
The correct answer is Option (1) → Both (A) and (R) are true and (R) is the correct explanation of (A).
Assertion (A): For maximisation of shareholders’ wealth, a company can use debt only up to a level. — True. Debt is cheap, but past a certain point it starts to lower the share price.
Reason (R): When a company increases debt, the financial risk faced by the equity holders increases, so their desired rate of return may increase. — True. More debt means more fixed interest and repayment, so equity holders carry more risk and want a higher return.
Why R explains A?
Because the return equity holders demand rises with debt, the cost of equity goes up. Beyond a point it rises sharply, so the share price may fall even though EPS has gone up. A falling share price means less wealth for shareholders, so debt is used only up to that level.
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.” |