Financial Decision
Sunrises Ltd. dealing in ready-made garments, is planning to expand its business operations in order to cater to the international market. To prepare for the future operations, the financial manager estimates that the raw materials will get costlier in the next year and the market will grow in the next 18 months. As the new orders will be placed by the international buyers, the earnings of the company will become more stable. He also suggested that it is advisable to increase production by investing in new machinery. For this purpose the company needs an additional rupees 80,00,000 to replace machines with modern machinery of higher production capacity. 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 rupees 8,00,000 and total capital investment was rupees 1,00,00,000.
Suggest the financial manager of Sunrises Ltd., what will happen if the company raises additional funds via issue of debentures.
Answer & explanation
Correct answer: option 3
The correct answer is Option (3) → Earning per share of company will decrease
Option (1) Cost of Debt will decrease — Incorrect. The cost of debt is the rate fixed on the debentures, 10%. Issuing them does not lower it.
Option (2) Cost of debt will increase — Incorrect. The passage gives the rate as 10%, and nothing in it suggests that the rate will rise.
Option (3) Earning per share of company will decrease — Correct. The company earns a return on investment of 8% (8,00,000 out of 1,00,00,000), but the debentures will cost 10%. Trading on equity, the use of fixed-cost debt to raise the return to shareholders, helps only when the return on investment is higher than the cost of debt. Here each rupee borrowed costs more than it earns, so the extra interest eats into the profit left for the shareholders and the new debt reduces the earning per share. Issuing debentures is therefore not a sound decision here.
Option (4) Earning per share of company will increase — Incorrect. The earning per share would rise only if the return on investment were above the 10% cost of debt.
Note: The passage is built on an NCERT exercise question on Sunrises Ltd. in the chapter ‘Financial Management’, which has been reproduced by NTA in the exam.
NCERT (2026-27 Edition): “Example II … In this example, the EPS of the company is falling with increased use of debt. It is because the Company’s rate of return on investment (RoI) is less than the cost of debt. …” “…In such cases, the use of debt reduces the EPS. This is a situation of unfavourable financial leverage. Trading on Equity is clearly unadvisable in such a situation.” “Short Answer Type … Suggest whether issue of debenture would be considered a rational decision by the company. Give reason to justify your answer. (Ans. No, Cost of Debt (10%) is more than ROI which is 8%).” |