Q.Sunrises Ltd. dealing in readymade garments, is planning to expand its business operations in order to cater to international market. For this purpose the company needs additional ₹80,00,000 for replacing machines with modern machinery of higher production capacity. The company wishes to raise the required funds by issuing debentures. The debt can be issued at an estimated cost of 10%. The EBIT for the previous year of the company was ₹8,00,000 and total capital investment was ₹1,00,00,000. Suggest whether issue of debenture would be considered a rational decision by the company. Give reason to justify your answer.

The key here is to compare the cost of the new debt with the return the company is earning on its existing capital. You don't need complex formulas — just a clear financial logic.

First, find the return on the existing capital. The company earned an EBIT of ₹8,00,000 on a total capital of ₹1,00,00,000. That gives a return of 8% (₹8,00,000 ÷ ₹1,00,00,000 × 100). This is the rate at which the company is currently generating profit from its total investment.

Now, the new debentures will cost 10%. This means the company will have to pay 10% interest on the ₹80,00,000 it borrows. But its existing business is only earning 8% on its capital. If the new machinery also earns at the same 8% rate, the return on the additional funds (₹80,00,000 × 8% = ₹6,40,000) will be less than the interest cost (₹80,00,000 × 10% = ₹8,00,000). This would reduce the overall profit available for shareholders. …

To understand whether Sunrises Ltd. should issue debentures, we first need to grasp the core idea behind cost of debt analysis. When a company borrows money — whether through debentures, loans, or bonds — it must pay interest on that borrowed capital. That interest is the “cost” of using someone else’s money. For the borrowing to be financially sensible, the company must earn a return on that borrowed money that is higher than the interest it pays. If it earns less, the debt becomes a burden that eats into profits.

In this case, Sunrises Ltd. wants to raise ₹80,00,000 by issuing debentures at an estimated cost of 10%. That means the company will have to pay 10% interest every year on this amount — ₹8,00,000 annually in interest expense. The question is: can the company generate enough additional profit from the new machinery to cover this interest and still have something left over?

Let’s look at the company’s current performance. The previous year’s EBIT (Earnings Before Interest and Taxes) was ₹8,00,000, and the total capital invested in the business was ₹1,00,00,000. This gives us a simple but powerful ratio: the return on capital employed (ROCE). Dividing EBIT by total capital, we get 8,00,000 ÷ 1,00,00,000 = 0.08, or 8%. So, for every ₹100 invested, the company currently earns ₹8 before interest and taxes.

Now, the new debentures will cost 10%. That means the company will have to pay ₹10 in interest for every ₹100 borrowed. But its existing business is only generating ₹8 per ₹100 of capital. If the new machinery does not dramatically improve the company’s profitability, the return on the additional capital will likely be similar to the existing 8% — which is less than the 10% interest cost. This is a classic red flag.