Question

Well-being ltd. is a company engaged in production of organic food. Presently it sells itsproducts through indirect channels of distribution. The company is planning to start its own show rooms and online portals. The financial manager suggested to use debt to invest in own showrooms and online portals. Company plans to raise debt capital of 40 lakhs through a loan from ICICI bank at 10% Interest. The present capital base of the company is 9 lakhs equity shares of 10 each. The rate of tax is 30% in the context of above case - Assuming expected rate of return same as current year, i.e., 15%, do you think the decision to use debt is justified. Show your working clearly.​

Answer 1

The decision to use debt to invest in own showrooms and online portals can be justified based on the expected rate of return and tax rate.

Step-by-step explanation:

The decision to use debt to invest in its own showrooms and online portals can be justified based on the expected rate of return and tax rate. By using debt, Well-being ltd. can leverage borrowed funds to expand its operations and potentially increase its profits. However, it is important to consider the cost of debt, which in this case is 10% interest, and the impact of the tax rate on the company's overall financial position.

To determine the justification, we need to compare the expected rate of return (15%) with the cost of debt (10%). If the expected rate of return is higher than the cost of debt, the decision to use debt is favorable. A higher expected rate of return indicates that the company's investments are likely to generate more profits than the interest expense.

1. Step 1: Calculate the interest expense on the debt capital: 40 lakhs * 10% = 4 lakhs per year
2. Step 2: Calculate the tax savings on interest expense: 4 lakhs * 30% = 1.2 lakhs per year
3. Step 3: Calculate the net interest expense after tax savings: 4 lakhs - 1.2 lakhs = 2.8 lakhs per year
4. Step 4: Calculate the net expected return after tax: 15% * (40 lakhs - 2.8 lakhs) = 5.94 lakhs per year
5. Step 5: Compare the net expected return after tax with the net interest expense after tax: 5.94 lakhs > 2.8 lakhs

Based on the calculations, the net expected return after tax (5.94 lakhs) is higher than the net interest expense after tax (2.8 lakhs). This suggests that using debt to invest in the showrooms and online portals is justified as it is expected to generate higher returns than the cost of debt.