A project which may not add to the existing profits should be financed by ______________
B. preference share capital.
C. equity capital.
D. public deposits.
The Correct Answer Is:
- A. debentures.
The correct answer is A. debentures.
To understand why debentures are the appropriate choice for financing a project that may not add to existing profits, let’s delve into the nature of debentures and why they are a suitable financing option. Additionally, we will explain why the other options (B, C, and D) are not as suitable for this purpose.
Why the correct answer is A. debentures:
Debentures are a form of long-term debt financing used by companies to raise capital. They are essentially bonds issued by a corporation, and they come with a promise to pay back the principal amount at a specified maturity date, along with periodic interest payments.
The key characteristics of debentures that make them an appropriate choice for financing a project that may not immediately add to existing profits include:
1. Fixed Obligation:
Debentures represent a fixed obligation for the company. Unlike equity capital, which involves sharing profits with shareholders, debenture holders are entitled to a fixed rate of interest and the return of the principal amount on maturity.
This means that, regardless of the project’s success or its impact on profits, the company is obligated to make interest and principal payments to debenture holders. Hence, they provide a stable and predictable source of funding.
2. No Profit-Sharing:
Debenture holders do not participate in the company’s profits. Unlike equity shareholders or preference shareholders (option B), who are entitled to a share of the profits in the form of dividends, debenture holders receive fixed interest payments and the principal amount at maturity.
This is crucial for a project that may not contribute to profits initially because it allows the company to service its debt without sharing a portion of the project’s potential future profits.
3. Interest Tax Deductibility:
Interest paid on debentures is typically tax-deductible as a business expense. This can provide a tax benefit to the company, reducing the after-tax cost of debt. In contrast, dividend payments to preference shareholders (option B) are not tax-deductible. This makes debentures a more cost-effective option for financing a project that may not immediately generate profits.
4. No Ownership Dilution:
Issuing equity capital (option C) involves selling ownership stakes in the company, which can dilute the ownership of existing shareholders. This is not ideal when the project’s profitability is uncertain or when the company wants to maintain its existing ownership structure.
In contrast, debentures do not dilute ownership since they are debt instruments, and the company remains wholly owned by its existing shareholders.
5. Broad Source of Funding:
Debentures can be offered to the general public or institutional investors, making them accessible to a wide pool of potential investors. This broad source of funding can be particularly advantageous when seeking financing for a project that may not immediately boost profits, as it allows for diversification of funding sources and reduces the reliance on a specific group of investors.
Why the other options are not correct:
B. Preference Share Capital:
Preference shares are a form of equity financing, and preference shareholders are entitled to a fixed dividend payment before common shareholders. While preference shares offer some advantages, such as a fixed dividend and no dilution of voting rights, they still involve sharing profits with shareholders.
This makes them less suitable for financing a project that may not immediately contribute to profits, as preference shareholders expect a regular dividend, which can strain the company’s resources even when profits are not forthcoming.
C. Equity Capital:
Equity financing, whether through common shares or preference shares, involves sharing the company’s ownership and profits with shareholders. While equity capital is an appropriate choice for projects with high profit potential, it may not be the best option for projects that are uncertain or may not add to profits initially.
Issuing equity capital dilutes ownership and entails ongoing dividend payments to shareholders, which could be financially burdensome if the project’s profitability is uncertain.
D. Public Deposits:
Public deposits are a form of short-term borrowing from the general public. They are typically used for working capital needs and are not a suitable option for financing long-term projects that may not immediately generate profits.
Public deposits are typically repaid within a short period, and the interest rates are generally higher than those on debentures. Therefore, using public deposits for long-term projects with uncertain profitability is not a financially prudent choice, as it can result in a liquidity mismatch and higher interest costs.
In conclusion, debentures are the most suitable option for financing a project that may not immediately add to existing profits. They provide a stable source of funding with fixed obligations, do not share in the company’s profits, offer tax benefits, and do not dilute ownership.
Other options such as preference share capital, equity capital, and public deposits involve sharing profits, diluting ownership, or are not suitable for long-term financing. Debentures are a prudent choice for managing financial obligations and ensuring a predictable source of funding, even in the face of uncertain project profitability.