Question

Shalini, 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 had been 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 modernisation 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 finance consultant, who told her that approximately ₹ 50 lakh would be required for undertaking the modernisation and expansion programme. He also informed her that the stock market was going through a bullish phase.

1. Keeping the above considerations in mind, name the source of finance Shalini should not choose for financing the modernisation and expansion of her food processing business. Give one reason in support of your answer. (2)
2. Explain any two other factors, apart from those stated in the above situation, which Shalini should keep in mind while taking this decision. (3)
3. With reference to equity and debt capital, what is Trading on Equity? (1)
4. State the circumstances when Trading on Equity is desirable. (2)

Answer 1

1. • Shalini should not choose debt capital (like loans, debentures).
   • Reason: Her business has high fixed operating costs and weak cash flow. Taking debt will add interest burden, increasing financial risk and may lead to liquidity problems.
2. 1. Control Consideration: If she issues equity shares, she may lose some control over her family business.
   2. Risk Tolerance: The level of risk she is willing to take debt increases financial risk, while equity dilutes control but has no fixed repayment.
3. Trading on Equity refers to using borrowed funds (debt) in the capital structure to earn a higher return for equity shareholders. If the return on investment (ROI) is higher than the cost of debt, equity shareholders benefit.
4. Trading on Equity is desirable when:
   • Return on Investment (ROI) is higher than the cost of debt.
   • The business has stable and regular earnings to pay interest on debt.