The Return on Investment (ROI) of a company ranges between $10 - 12 %$ for the past three years. To finance its future fixed capital needs, it has the following options for borrowing debt:
Option 'A': Rate of interest $9 %$
Option 'B': Rate of interest $13 %$
Which source of debt, 'Option A' or 'Option B', is better? Give reason in support of your answer. Also state the concept being used in taking the decision.

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Solution

The general principle of borrowing at an interest rate is "lower the interest rate, lesser the interest paid". This is because a lower interest rate is essentially lowering the cost of your loan. For example if the loan you have taken is Rs 100, with an interest rate of 13% you are paying back Rs 113 to the lender. Whereas, with an interest rate of 9%, you are paying back Rs 109. Hence, lower the interest rate, lower the costs you face. Furthermore, since the return on investment of the company is 10%-12%, borrowing at an interest rate of 13 % will definitely give negative returns.

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