Question

Debt is____cheaper, but more__risky for a business because the payment of interest and the return of principal is obligatory for the business.

• A. Cheaper, risky
• B. Cheaper, safe
• C. Expensive, risky
• D. Expensive, safe

Answer 1

The Correct Option is A

Debt is a financial instrument used by businesses to fund operations or growth. It is typically cheaper than equity financing because the interest on debt is tax-deductible, making it a cost-effective option. However, debt is also riskier because it requires the business to fulfill its obligations of paying interest and returning the principal amount as per the agreed schedule. Defaulting on these obligations can lead to severe financial consequences, including insolvency. 

Debt Characteristics	Reason
Cheaper	Interest is tax-deductible
Risky	Payment obligations can lead to financial distress

Among the given options, the correct answer is "Cheaper, risky".

Answer 2

To determine the correct description of debt for a business, let's analyze the statement and each option in detail:

Statement Analysis

The statement says, "Debt is , but is more for a business because the payment of interest and the return of principal is obligatory for the business." This implies that debt has two characteristics: one related to its cost and the other related to the risk associated with it.

Options Analysis

Cheaper, risky (1)

Definition: Debt is often considered cheaper than equity because the interest payments are tax-deductible and the cost of debt is typically lower than the cost of equity. However, debt is also riskier for a business because it requires regular payments of interest and the return of the principal, which can be a burden if the business faces financial difficulties.

Why Correct: This option correctly describes debt as being cheaper due to tax advantages and lower interest rates compared to equity, but also riskier due to the obligatory payments.

Cheaper, safe (2)

Definition: While debt can be cheaper, it is not necessarily safe for a business. The obligation to make interest and principal payments can put a strain on the business's cash flow, making it riskier.

Why Not: This option incorrectly describes debt as safe, which is not accurate given the obligatory nature of debt payments.

Expensive, risky (3)

Definition: Debt is not typically considered expensive, as it often has a lower cost than equity. However, it is riskier due to the obligatory payments.

Why Not: This option incorrectly describes debt as expensive, which is not accurate given the tax advantages and lower interest rates compared to equity.

Expensive, safe (4)

Definition: Debt is not typically considered expensive, and it is not safe for a business due to the obligatory nature of debt payments.

Why Not: This option incorrectly describes debt as both expensive and safe, which is not accurate.

Conclusion

The correct answer is: (1) Cheaper, risky

Debt is often cheaper than equity due to tax advantages and lower interest rates, but it is riskier for a business because of the obligatory payments of interest and principal.