Before borrowing, a company must see that its cash flows can meet its debt service commitments. What do debt service commitments mean?
Answer & explanation
Correct answer: option 1
The correct answer is Option (1) → Payment of interest and repayment of principal
Option (1) Payment of interest and repayment of principal — Correct. Debt must be serviced regularly. The lender gets interest every year and the principal back on maturity. Both payments are obligatory, so the cash flows must cover them with a buffer.
Option (2) Payment of interest and payment of preference dividend — Incorrect. Preference dividend is paid on preference share capital, which is not debt. It is a fixed financial charge, but it is not paid to lenders. The principal is also missing here.
Option (3) Repayment of principal and payment of floatation costs — Incorrect. Floatation costs are the costs of raising funds, such as the expenses of a public issue. They are paid once, when the funds are raised.
Option (4) Repayment of principal and payment of preference dividend — Incorrect. Repayment of principal is part of debt service, but preference dividend goes to preference shareholders. Interest, the yearly payment to lenders, is missing.
NCERT (2026-27 Edition): “1. Cash Flow Position: Size of projected cash flows must be considered before borrowing. Cash flows must not only cover fixed cash payment obligations but there must be sufficient buffer also. It must be kept in mind that a company has cash payment obligations for (i) normal business operations; (ii) for investment in fixed assets; and (iii) for meeting the debt service commitments i.e., payment of interest and repayment of principal.” “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.” “9. Risk Consideration: As discussed earlier, use of debt increases the financial risk of a business. Financial risk refers to a position when a company is unable to meet its fixed financial charges namely interest payment, preference dividend and repayment obligations. …” |