ACCA Applied Knowledge · Business and Technology · Accounting and finance functions within business organisations
A company's directors increase borrowing sharply to fund expansion. Which statement about the effect on the company's financial risk is most accurate?
Higher gearing raises fixed interest obligations, so returns to shareholders fluctuate more and the risk of being unable to pay interest rises. Debt can be a cheaper source and interest may be tax-deductible, but those benefits do not reduce the increased financial risk.
- AHigher gearing increases fixed interest commitments, so profits available to shareholders become more volatileCorrect
- BHigher gearing reduces financial risk because debt is cheaper than equity
- CHigher gearing has no effect on shareholder returns because interest is tax-deductible
Explanation
Interest must be paid whatever the profit level, so greater debt makes earnings for shareholders more variable and raises the risk of default. Debt may be cheaper, and interest tax-deductible, but neither removes the added financial risk.
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