How does raising of long term funds through debt affect the return on shareholders' funds? Explain with an example.
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Answer:
The financial requirement of a firm can be met through ownership capital and/or by the owners.In case of a company, it refers to the amount of funds raised by issuing shares. The maincharacteristic of the ownership capital is that its contributors are entitled to get dividend out ofearnings after the payment of interest and taxes. Hence, the rate of return on such capital dependsupon the level of profits earned, and, if there are no profits, no dividend may be paid.Borrowed capital, on the other hand, refers to the amount of funds raised through long term loansand debentures on which its contributors are entitled to a fixed rate of interest which has to bepaid at regular intervals (half-yearly or yearly) irrespective of the profits earned. There is also acommitment that the principal amount shall be repaid on maturity. However, it is still consideredadvantageous to finance business activities through borrowed capital because if the rate of earningsfrom the planned business investment is expected to be better than the rate of interest on theborrowed funds, it shall ensure higher returns on owners’ funds.
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