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IAI Actuarial Core Principles · Business Finance · Structure and methods of financing a company

Which of the following is a recognised disadvantage of a company raising a high proportion of its finance as debt rather than equity?

High debt raises the risk of financial distress because interest and capital repayments are contractual obligations payable regardless of profits. Debt is normally cheaper than equity, interest is generally tax-deductible, and borrowing does not dilute ownership.

  1. AInterest is not tax-deductible in India
  2. BLenders gain voting control over ordinary shareholder decisions automatically
  3. CFixed interest and repayment obligations increase the risk of financial distressCorrect
  4. DDebt always costs more than equity
  5. Debt dilutes existing shareholders' earnings per share

Explanation

Debt carries contractual interest and repayment regardless of profits, raising default and distress risk. Interest is generally tax-deductible, debt is usually cheaper than equity, and it does not dilute ownership.

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