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.
Which of the following factors do not affect the choice of capital structure?
Answer & explanation
Correct answer: option 2
The correct answer is Option (2) → Inflation
Capital structure is the mix of debt and equity a company uses to raise its long-term funds. The factors affecting the choice of capital structure are:
| Cash flow position | Interest coverage ratio | Debt service coverage ratio | Return on investment | Cost of debt |
| Tax rate | Cost of equity | Floatation costs | Risk consideration | Flexibility |
| Control | Regulatory framework | Stock market conditions | Capital structure of other companies |
Option (1) Risk — A factor affecting the choice (Incorrect). More debt means more fixed interest to pay, so the financial risk rises. A company adds debt only if its total risk stays within limits.
Option (2) Inflation — Not a factor affecting the choice (Correct). Inflation is a factor affecting working capital: with rising prices, more money is needed to keep the same level of production and sales. It is not a factor in the choice of capital structure, which is about the mix of debt and equity.
Option (3) Floatation cost — A factor affecting the choice (Incorrect). Raising money through an issue costs brokerage, commission and printing. Where the cost of one source is lower, it is preferred.
Option (4) Return on investment — A factor affecting the choice (Incorrect). If the return on investment is higher than the cost of debt, using more debt raises the earnings per share. This is trading on equity.
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): “Factors affecting the Choice of Capital Structure Deciding about the capital structure of a firm involves determining the relative proportion of various types of funds. This depends on various factors. …” “4. Return on Investment (RoI): If the RoI of the company is higher, it can choose to use trading on equity to increase its EPS, i.e., its ability to use debt is greater. …” “8. Floatation Costs: Process of raising resources also involves some cost. Public issue of shares and debentures requires considerable expenditure. …” “9. Risk Consideration: As discussed earlier, use of debt increases the financial risk of a business. …” |