Owners of deeply indebted and chronically unprofitable small businesse

The correct answer choice is option (C).

Let us see why.

Passage Analysis

1. Owners of companies that are
a) In-debt (i.e. have loans to pay off)
b) Chronically unprofitable (i.e. consistently not making profits)
sometimes try to convince others to invest in their companies.
2. Money obtained from such investors will be used to pay off debts => this money is not available to expand the operations => sales growth will not happen.
i.e. this money will not result in an increase in Sales.
3. Because of the above reason, many people are reluctant to invest in these companies.
4. However, such investments have been observed to provide handsome returns to the investors in the very first year of investment

Question: Logical Explanation for the surprisingly handsome return on investments

Thought Process:

We know that

Profit = Sales - Expenses

Also,

Return of Investment = (Net Profit/Investment)*100%

We know that Sales is not going to increase as a result of the money. But what if because of debts being paid off using investment money, the expenses of the firms come down.

So, Sales being same, Expenses being lesser -> Higher Profit -> Higher Return on Investment

This logic definitely makes sense. Let us review the answer choices.

(A) Investors usually choose to reinvest their returns on such investments.
Irrelevant. What investors choose to do with the returns they have obtained is not relevant to how these returns were obtained.

(B) Expanding production in such companies would usually require more funds than would paying off debts.
Irrelevant. We already know that expansion of production is not happening with the amount received by the companies. This will not explain why returns are so good, given no production expansion.

(C) Paying off debts, by saving a company the money it would otherwise owe in interest, decreases the company’s overall expenses and thereby increases its profits.

Correct. This is exactly what we discussed above. Lower Expenses -> Higher Profits -> Higher Returns.

(D) Banks are reluctant to lend money to any company that is already heavily in debt and chronically unprofitable.
Irrelevant. This only tells us again that it may be a bad idea to invest in such companies (already highlighted in the passage). It does not tell us why returns are so good when people invest in such companies.

(E) If the sales of a company do not grow, there is usually little need to devote a large share of company resources to expanding production.
Irrelevant. This only tells us that if a company is struggling with regard to Sales (not growing), it should probably not devote a large share of resources to expanding production. It can instead focus, say, on building efficiency (cost cutting) with existing production. But, this statement is also not really relevant to why returns are so good when people invest in such struggling companies.

Cheers!