Question 2 OR (b)
Debt or equity for an expansion: EPS comparison
11 marks
- Time to write
- About 22 minutes
From an older CBCS paper
Question
Question 2 OR (b) · 11 marksA company earns a profit of Rs. 3,60,000 per annum, after it has met its interest liability of Rs. 1,44,000 on 12% debentures. The rate of tax is 30%. The number of its equity shares of Rs. 10 each is 96,000, and its retained earnings amount to Rs. 14,40,000. It proposes to take up an expansion scheme needing a sum of Rs. 4,80,000. After expansion, the company is expected to earn the same return on investment as at present. The expansion funds can be raised either as debt at the rate of 12%, or by an issue of equity shares at par. You are now required to:
- Compute the earning per share where:
the additional funds were raised by way of debt
the additional funds were raised by an issue of equity shares
- Advise the company which source of finance is preferable.
Reworded from the university paper: names and figures differ, the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.
Before you write
Read off the question and its marks
Read from the question
- Compute…Advise…Two asks in one question: answer both.
- ComputeFormula first, then the working, then the answer with its unit (₹, %, units).
- AdviseEnd with a one-line decision that follows from your figures.
What the paper leaves open
"The same return on investment as at present" is read as the present return on total capital employed (equity, retained earnings and debentures, at book value).
Write it in this order
- Read the data; note exactly what is asked 1 min
- 1 Present EBIT, capital employed and return on it 3 marks 5 min
- 2 EBIT after expansion 1 mark 2 min
- 3 EPS with debt and with equity 5 marks 9 min
- 4 Advice with reasons 2 marks 4 min
- Check: arithmetic, units (₹, %), final answer underlined 1 min
Short on time? End with step 4's one-line decision, whatever happens: never leave the figures without it.
Try it first. About 22 minutes for 11 marks. Write it out, then open the solution.
Solution
Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.
Present position. EBIT = profit after interest 3,60,000 + interest 1,44,000 = ₹5,04,000. The 12% debentures are 1,44,000 ÷ 12% = ₹12,00,000.
| Particulars | ₹ |
|---|---|
| Equity share capital (96,000 × ₹10) | 9,60,000 |
| Retained earnings | 14,40,000 |
| 12% Debentures | 12,00,000 |
| Capital employed | 36,00,000 |
Return on capital employed = 5,04,000 ÷ 36,00,000 = 14% (paper note). After the expansion the same 14% is earned on ₹40,80,000: EBIT = ₹5,71,200.
(i) EPS under each source of finance (₹). EBIT-EPS analysis compares the EPS that each financing pattern gives at a given EBIT; the financing pattern does not change the EBIT itself.
| Particulars | Debt (12%) | Equity shares at par |
|---|---|---|
| EBIT | 5,71,200 | 5,71,200 |
| Less: interest | 2,01,600 | 1,44,000 |
| EBT | 3,69,600 | 4,27,200 |
| Less: tax @ 30% | 1,10,880 | 1,28,160 |
| EAT | 2,58,720 | 2,99,040 |
| Number of equity shares | 96,000 | 1,44,000 |
| EPS | 2.695 | 2.077 |
(Interest under debt = 1,44,000 + 12% × 4,80,000; new shares under equity = 4,80,000 ÷ ₹10 = 48,000.)
(ii) Advice. Debt is preferable: it gives an EPS of about ₹2.70 against ₹2.08. The new funds earn 14% before tax while debt costs only 12%, so the surplus goes to the existing shareholders. Using fixed-interest debt to earn more than its cost, so as to raise the return on the owners' equity, is financial leverage or trading on equity. An equity issue would spread the earnings over 50% more shares. The present EPS is 3,60,000 × 0.70 ÷ 96,000 = ₹2.625, so debt raises it and equity lowers it. The debt does add financial risk, the additional risk a shareholder bears when the company uses debt in addition to equity; it is a risk a firm earning 14% on 12% debt can carry.
Where the 11 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Present EBIT, capital employed and return on it | 3 |
| 2 | EBIT after expansion | 1 |
| 3 | EPS with debt and with equity | 5 |
| 4 | Advice with reasons | 2 |
| Total | 11 |
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