Question 4 (b)
Choosing the level of debt: EPS and financial break-even points
11 marks
- Time to write
- About 22 minutes
From an older CBCS paper
Question
Question 4 (b) · 11 marksA company must raise ₹ 12,00,000 for a new project expected to yield an annual EBIT of ₹ 1,92,000. It is considering issuing equity shares together with some debt, and may raise a debt of ₹ 1,20,000, ₹ 4,80,000 or ₹ 7,20,000. The rates at which debt is available to it are below:
| Upto ₹ 1,20,000 | 8% |
| Over ₹ 1,20,000 and Upto ₹ 6,00,000 | 12% |
| Over ₹ 6,00,000 | 18% |
The current market price of its equity share is ₹ 25, expected to fall to ₹ 20 if more than ₹ 6,00,000 is borrowed. The company's tax rate is 50%. Suggest the best financing alternative. Also calculate the financial break even point of each of the three options. 11
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
- Suggest…Calculate…Two asks in one question: answer both.
- calculateFormula first, then the working, then the answer with its unit (₹, %, units).
What the paper leaves open
The debt rates are read as applying to the whole borrowing at the slab it falls in, not as marginal slabs; the answer states this and shows the slab reading.
Write it in this order
A step that gives the answer away stays hidden: tap it to see it.
- Read the data; note exactly what is asked 1 min
- 1 Interest and number of shares under each alternative 3 marks 5 min
- 2 EPS under each alternative 4 marks 7 min
- 3 Best alternative, with reasons 2 marks 4 min
- 4 Financial break-even points 2 marks 4 min
- Check: arithmetic, units (₹, %), final answer underlined 1 min
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.
Approach. For a given EBIT, each financing pattern gives a different EPS; the pattern does not change the EBIT itself. Each borrowing is charged the rate of the slab it falls in, on the whole amount (paper note); equity is issued at ₹25, or ₹20 if more than ₹6,00,000 is borrowed.
EPS under the three alternatives (₹)
| Particulars | Debt ₹1,20,000 | Debt ₹4,80,000 | Debt ₹7,20,000 |
|---|---|---|---|
| Rate of interest | 8% | 12% | 18% |
| EBIT | 1,92,000 | 1,92,000 | 1,92,000 |
| Less: interest | 9,600 | 57,600 | 1,29,600 |
| EBT | 1,82,400 | 1,34,400 | 62,400 |
| Less: tax @ 50% | 91,200 | 67,200 | 31,200 |
| EAT | 91,200 | 67,200 | 31,200 |
| Equity raised (12,00,000 − debt) | 10,80,000 | 7,20,000 | 4,80,000 |
| Issue price | 25 | 25 | 20 |
| Number of shares | 43,200 | 28,800 | 24,000 |
| EPS | 2.111 | 2.333 | 1.300 |
Best alternative. Borrowing ₹4,80,000 gives the highest EPS, ₹2.33. Borrowing ₹7,20,000 pushes the rate to 18%, far above the project's 16% return on capital (1,92,000 ÷ 12,00,000), and also lowers the issue price, so EPS falls to ₹1.30.
Financial break-even points. The financial break-even EBIT is the EBIT that just covers the fixed financial charges; with debt only, it equals the interest charge. Below it EPS is negative:
- debt ₹1,20,000: ₹9,600;
- debt ₹4,80,000: ₹57,600;
- debt ₹7,20,000: ₹1,29,600.
The other reading. If the rates apply slab by slab (8% on the first ₹1,20,000, 12% on the next ₹4,80,000, 18% beyond), interest is ₹9,600, ₹52,800 and ₹88,800, and EPS ₹2.11, ₹2.42 and ₹2.15: ₹4,80,000 of debt is still the best.
Where the 11 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Interest and number of shares under each alternative | 3 |
| 2 | EPS under each alternative | 4 |
| 3 | Best alternative, with reasons | 2 |
| 4 | Financial break-even points | 2 |
| Total | 11 |
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