Question

(Answer to all the following questions collectively shall be 100 to 150 words)
Requirements: a. Why are equity shareholders called residual claimants? Explain with reasons ) b. Why is debt capital considered the cheapest source of funds? Explain with reasons.   

Answer 1

(a) Answer :-

Equity shareholders are called residual claimants because they are paid last in case of income distribution as well as liquidation.

When all other obligations like all expenses , interest on debt , dividend on preferred shares are paid , after then any profit if remaining is distributed to equity shareholders as dividend.

Same in case of liquidation , all legal expenses , payment to secured and unsecured creditors , debenture holders, preference shareholder are made before any payment to equity shareholders. Equity shareholders are paid their capital last in case of wind up also.

So, equity shareholders are called residual claimants.

(b) Answer :-

Debt is considered the cheapest source of finance because the interest on debt is tax deductible . So, interest on debt reduces the amount of tax to be paid . Cost of debt is reduced because of tax deductbility and this is a reason that debt is considered cheapest source of capital.

Another reason could be legal compulsion to pay interest and pay back the capital so, it leads to assurance of income and capital back and because of this reason also, the interest rate on debt is not very high as compared to other sources of financing.

For these reasons , debt capital is considered cheapest source of capital.