Read the following text and answer the following questions on the basis of the same.
Charvi, after acquiring a degree in Hotel Management and Business Administration took over her family food processing company of manufacturing pickles, jams and squashes. The business was established by her great grandmother and was doing reasonably well. However, the fixed operating costs of the business were high and the cash flow position was weak. She wanted to undertake modernization of the existing business to introduce the latest manufacturing processes and diversify into the market of chocolates and candies. She was very enthusiastic and approached a Financial Consultant, who told her that approximately Rs. 50 lakhs would be required for undertaking the modernization and expansion programme. The Financial Consultant advised her about the judicious mix of equity (40%) and Debt (60%). He also suggested her to take loan from Financial Institution as the cost of raising funds from Financial Institutions is low. Though this will increase the financial risk, but will also raise the return to equity shareholders. He also apprised her that issue of debt will not dilute the control of equity shareholders. At the same time, the interest on loan is a tax deductible expense for computation of tax liability. After due deliberations with the Financial Consultant, Charvi decided to raise funds from a Financial Institution.
State the reason why Charvi should choose equity as the source of finance?
Answer & explanation
Correct answer: option 4
The correct answer is Option (4) → Due to weak cash flow position, the firm may not be able to honor fixed cash payment obligations.
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) If stock markets are bullish, shareholders will earn less. — Incorrect. In a bullish market share prices rise, so shareholders gain. A bullish market also makes it easier to raise money through equity. The statement is false.
Option (2) Fixed operating cost will increase the business risk. — Should also be correct, though not the answer given by NTA. The passage says Charvi’s fixed operating costs are high, and high fixed costs such as rent and salaries raise business risk. A firm that already carries high business risk should keep its financial risk low by using less debt, so this also points towards equity. Option (4) states the reason more fully: weak cash flows cannot meet the fixed payments that debt demands.
Option (3) Dividend is tax deductible — Incorrect. The feature is reversed. Interest on debt is a tax-deductible expense. Dividend is paid out of profit after tax, so it saves no tax.
Option (4) Due to weak cash flow position, the firm may not be able to honor fixed cash payment obligations. — Correct. Debt brings fixed cash payments: interest and repayment of the loan must be paid on time, whatever the profit. The passage says Charvi’s cash flow position was weak. With weak cash flows she may fail to make these payments. Equity carries no such fixed obligation, because dividend is paid only when the company can afford it.
NCERT (2026-27 Edition): “Factors affecting the Choice of Capital Structure … 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. …” “Fixed Operating Costs: If a business has high fixed operating costs (e.g., building rent, Insurance premium, Salaries, etc.), It must reduce fixed financing costs. Hence, lower debt financing is better. …” |