Question

Read the following statements carefully :

Statement I : Higher fixed operating costs result in higher business risk.

Statement II : If the firm’s business risk is lower, the firm’s capacity to use debt is higher.

In light of the given statements, choose the correct alternative from the following :

• A. Statement I is true and Statement II is false.
• B. Statement I is false and Statement II is true.
• C. Both Statement I and Statement II are true.
• D. Both Statement I and Statement II are false.

Hint:

Fixed operating costs make profit swing more, which is higher business risk. A firm with lower business risk can carry more debt.

Answer 1

The Correct Option is C

Step 1: Understand the two ideas:
Business risk is the variability in operating profit (EBIT) because of conditions in the business.
Debt capacity is how much debt a firm can safely carry. These two ideas are tested in the statements.

Step 2: Check Statement I:
Fixed operating costs have to be paid whatever the sales are.
If sales fall, profit falls much more because these costs do not fall. So EBIT becomes more variable.
Higher fixed operating costs therefore mean higher business risk. Statement I is TRUE.

Step 3: Check Statement II:
A firm with low business risk has steady operating profit, so it can safely pay fixed interest.
Such a firm can use more debt. A firm with high business risk should use less debt.
So lower business risk means higher capacity to use debt. Statement II is TRUE.

Step 4: Choose the option:
Both statements are true, so option (C) is correct.
(A) and (B) wrongly call one true statement false. (D) wrongly calls both false.

Final Answer:
Both statements are true, option (C).