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#2 - Owners of deeply indebted and chronically unprofitable

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Complete Question Explanation

Resolve the Paradox. The correct answer choice is (C)

The stimulus observes that even though money invested in businesses that are heavily indebted and unprofitable is used to pay off debts and will not stimulate sales growth, investments in such companies frequently pay off well in the very first year.

The paradox is not hard to resolve; clearly, a heavily indebted business is paying a great deal in interest and is stymied in its attempts to use capital efficiently. At the very least, it is somewhat likely that an investor will get as return something similar to what the bank got as interest. Since you are asked to explain the “surprising” results, you should focus on that resolution.

Answer choice (A): This incorrect choice does not help to explain the paradox, because it only explains what the investors do with their returns. You should not assume that reinvestment of the returns explains the high returns, because it does not explain the root cause of returns to begin with.

Answer choice (B): Even if expanding production would require more funds than would paying off debts, this difference would not explain why returns are so handsome simply from paying off debt, so this choice is wrong.

Answer choice (C): This is the correct answer choice. Part of the reason such indebted companies are unprofitable is their indebtedness, and eliminating interest payments would effectively return money to the bottom line-- and increasing profits creates return on investment.

Answer choice (D): You were not supposed to explain why people are reluctant to invest even though such investments often pay off; you were supposed to explain why the investments actually pay off (the “surprising results”). This choice is off-task, and incorrect.

Answer choice (E): While this choice would help explain that few additional expenses in production might be expected, the fact that production remains unexpanded would not help explain why the investment in the company proves profitable, so this incorrect response cannot explain why there is a good return on the investment.