Question

‘’Adwitiya‟ is a company enjoying market leadership in the food brands segment. It’s portfolio includes three categories in the Foods business namely Snack Foods, Juices and Confectionery. Keeping in mind, the growing demand for packaged food it now plans to introduce ready-ToEat Foods. Therefore, the company has planned to undertake investments of nearly Rs. 450 crores for its new line of business. As per the current financial report, the interest coverage ratio of the company and return on investment is higher. Moreover, the corporate tax rate is high.

In context of the above case:

1. As a financial manager of the company, which source of finance will you opt for debt or equity, to raise the required amount of capital? Explain by giving any two suitable reasons in support of your answer.

2. Why are the shareholder’s of the company like to gain from the issue of debt by the company?

Answer 1

1. As a financial manager of the company, I will opt for debt to raise the required amount of capital.

I support my decision by giving the following reasons:

i) Interest coverage ratio:

• The interest coverage ratio measures a company's ability to cover its interest expenses with its earnings before interest and taxes (EBIT). A higher interest coverage ratio indicates that the company is generating sufficient earnings to meet its interest obligations comfortably.
• In this case, since the interest coverage ratio of the company is higher, it suggests that Adwitiya has strong earnings relative to its interest expenses. This indicates that the company has the capacity to take on additional debt without significantly increasing its financial risk.
• By opting for debt financing, Adwitiya can capitalize on its strong interest coverage ratio to secure favorable borrowing terms, such as lower interest rates and longer repayment periods. This can help minimize the cost of capital and enhance the company's profitability.

ii) Tax rate:

• The corporate tax rate plays a significant role in determining the cost of debt and equity financing. In this case, if the corporate tax rate is high, it implies that the tax shield associated with interest expenses is more significant.
• Interest expenses on debt are tax-deductible, which means that a higher corporate tax rate results in greater tax savings for the company. This tax advantage makes debt financing more attractive compared to equity financing, especially when the tax rate is high.
• By utilizing debt financing, Adwitiya can benefit from the tax deductibility of interest expenses, resulting in lower overall financing costs and increased after-tax profitability.

2. The shareholders of the company are likely to gain from the issue of debt by the company because the return on investment is higher. It helps a company to take advantage of trading on equity to increase the earnings per share