Test: Capital Structure - UGC NET MCQ

Statement 1 is correct because the costs of capital indeed represent the expenses a company incurs to acquire funding, which must be covered by revenue for sustainable growth.

Statement 2 is incorrect; in fact, equity shareholders typically possess more authority and voting rights compared to preference shareholders and debenture holders, who have limited or no voting rights.

Therefore, only Statement 1 is correct.

The two primary types of equity capital are common stock and preferred stock. Common stock represents ownership in a company and typically comes with voting rights, while preferred stock usually does not have voting rights but offers fixed dividends. Understanding these distinctions is crucial for investors as they influence shareholder rights and returns on investment.

Retained earnings are primarily used to reinvest in a company's operations, which helps enhance financial stability and support future growth. By retaining profits instead of distributing them as dividends, companies can fund new projects, expand operations, or strengthen their balance sheets. This strategy is crucial for long-term success as it allows businesses to leverage their own profits for growth rather than relying solely on external funding sources.

The two primary sources of capital that constitute a company's capital structure are debt and equity. Debt refers to borrowed funds that must be repaid over time, often with interest, while equity represents ownership in the company, typically through shares. Understanding the balance between these two sources is crucial for companies as it influences their financial stability, growth potential, and risk profile. An interesting fact is that companies with a higher proportion of debt in their capital structure may benefit from tax shields but also face greater financial risk during downturns.

- The Assertion is correct as a strong capital structure does indeed lead to an increase in market valuation by instilling confidence in investors.

- The Reason is also correct, as an optimal capital structure can prevent financial distress, which in turn maintains or improves market valuation.

- The Reason serves as a correct explanation for the Assertion because a strong capital structure reduces risk, leading to higher investor confidence and thus a better market valuation.

Short-term bank loans are not typically considered a long-term funding source in a company's capital structure. Instead, they are classified as current liabilities because they are expected to be repaid within a year. In contrast, preference shares, retained earnings, and long-term loans are all examples of long-term financing options that support a company's operations and growth strategies over an extended period. Understanding the distinction between short-term and long-term financing is essential for effective financial management, as it impacts liquidity and investment strategies.

Statement 1 is correct because the interest on debt is tax-deductible, which reduces the effective cost of borrowing. Statement 2 is also correct, as high financial leverage increases the risk of bankruptcy and can lead to a higher cost of capital due to the increased risk perceived by investors. Therefore, both statements are correct.

- The Assertion is correct because debt capital encompasses both short-term (like commercial paper) and long-term (like bonds) financing methods.

- The Reason is also correct as it accurately describes the purpose of an ideal capital structure.

- However, the Reason does not directly explain the Assertion, as it speaks to the purpose of capital structure rather than the specifics of what debt capital includes. Thus, the correct answer is Option B.

- Assertion Evaluation: The assertion is true. Companies with high financial leverage indeed face greater risks during economic downturns due to their reliance on debt.

- Reason Evaluation: The reason is also true. High debt leads to increased fixed obligations, which can limit a company's ability to respond effectively to adverse conditions.

- Explanation: The reason correctly explains the assertion, as the financial obligations associated with high leverage can indeed lead to financial distress in tough economic times.

- The Assertion is true as companies in mining face significant operational risks, leading them to prefer lower debt ratios.

- The Reason is also true; banking and insurance sectors can support higher debt levels due to the nature of their operations and regulatory frameworks.

- Furthermore, the Reason correctly explains the Assertion by contrasting the preferences of different industries based on their operational characteristics. Therefore, the correct answer is Option A.