Question

Read the following text and answer the following questions on the basis of the same:

Mr. A. Bose is running a successful business. Mr. Bose is the owner of R. K. Cement Ltd. Mr. Bose decided to expand his business by acquiring a Steel Factory. This required an investment of ₹ 60 crores. To seek advice in this matter, he called his financial advisor Mr. T. Ghosh who advised him about the judicious mix of equity (40%) and Debt (60%). Employ more of cheaperdebt may enhance the EPS. Mr. Ghosh also suggested him to take loan from a 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 him 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 Mr. Ghosh, Mr. Bose decided to raise funds from a financial institution.

1. Identify and define the concept of Financial Management as advised by Mr. Ghosh in the above situation. (2)
2. In the above case, why did Mr. Ghosh suggested to raise more fund from debt? (1)
3. “Mr. Ghosh advised him about the judicious mix of equity (40%) and Debt (60%)”. What is the proportion of debt in the overall capital called? Explain the concept with a numerical example. (3)
4. What is the practice of employing more of cheaper debt to enhance the Earning per share called? Enumerate any one pre-requisite of such practice. (2)

Answer 1

1. Capital Structure: Capital Structure refers to the mix of debt and equity used by a company to finance its operations and growth. It is the combination of owners’ funds (equity) and borrowed funds (debt) in the total capital of a business.
2. Mr. Ghosh suggested to raise more debt because:
   • Debt is a cheaper source of finance compared to equity.
   • Interest on debt is tax-deductible, which reduces the company’s tax burden.
   • Debt does not dilute control of existing equity shareholders.
3. The proportion of debt in the overall capital is called the Capital Structure Ratio or Debt-Equity Mix.
   • It shows the percentage of debt and equity used to finance the business. A balanced capital structure helps manage risk and return.
   • Example: If total capital = ₹ 100 crores,
     Debt = ₹ 60 crores (60%),
     Equity = ₹ 40 crores (40%).
     Therefore, Debt-Equity Ratio = 60 : 40 or 1.5 : 1.
4. • This practice is called Trading on Equity.
   • One Pre-requisite: The company’s Return on Investment (ROI) must be higher than the cost of debt.