Which of the following statement is true?

Answer & explanation

Correct answer: option 1

The correct answer is Option (1) → The cost of debt is usually lower than the cost of equity for a firm.

Note: The given answer is as per the official NTA Answer Key. For this question, Option (2) could also be a possible answer, as explained below.

Option (1) The cost of debt is usually lower than the cost of equity for a firm. — Correct. The lender gets an assured return and gets his capital back. His risk is lower, so he accepts a lower rate of return. Interest is also a deductible expense for tax, while dividend is paid out of profit after tax. So debt is the cheaper source.
Option (2) Equity is riskier than debt. — Should also be correct, though not the answer given by NTA. Seen from the side of the investor, this is true: the lender earns an assured return and gets his capital back, so the lender’s risk is lower than the equity shareholder’s risk. Seen from the side of the business, as Option (3) is worded, the risk runs the other way. Interest and repayment of debt must be paid whatever the profit, and a default can force the business into liquidation. Equity carries no such compulsion, so it is riskless for the business.
Option (3) Debt is expensive but is less risky for a business. — Incorrect. Both halves are reversed. Debt is cheaper but more risky for a business.
Option (4) A capital structure is said to be optimal when the proportion of debt and equity is such that it results in an increase in the value of debtor’s money. — Incorrect. Capital structure is optimal when the mix of debt and equity increases the value of the equity share, that is, the wealth of the shareholders. The lender’s money has no part in it.

NCERT (2026-27 Edition): “Capital Structure … The cost of debt is lower than the cost of equity for a firm because the lender’s risk is lower than the equity shareholder’s risk, since the lender earns an assured return and repayment of capital and, therefore, they should require a lower rate of return. Additionally, interest paid on debt is a deductible expense for computation of tax liability whereas dividends are paid out of after-tax profit. Increased use of debt, therefore, is likely to lower the over-all cost of capital of the firm provided that the cost of equity remains unaffected. Impact of a change in the debt-equity ratio upon the earning per share is dealt with in detail later in this chapter. Debt is cheaper but is more risky for a business because 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. There is no such compulsion in case of equity, which is therefore, considered riskless for the business. …”