Question 2 (b)
EPS, financial break-even and indifference EBIT for two financing plans
10 marks
- Time to write
- About 20 minutes
From an older CBCS paper
Question
Question 2 (b) · 10 marksMNO ltd. is evaluating two plans of financing. Assuming a tax rate of 50% and an expected EBIT of Rs 4.8 lakh, calculate:
The EPS for each plan,
Each plan's financial break-even point,
The level of EBIT at which the company would be indifferent as to which of the two plans is selected.
| Plan A | Plan B | |
|---|---|---|
| Bonds | Rs.96,000 at 9% | Rs.1,80,000 at 10% |
| 10% Preference stock | 4,800 shares of Rs 60 each | 2,400 shares of Rs 70 each |
| Common stocks | 24,000 shares | 27,600 shares |
(5,10)
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
- (i)–(iii)3 items, each marked on its own: give each its share.
- Assuming a tax rate of 50%…The paper fixes this: use it as given, and say so in your answer.
- calculateFormula first, then the working, then the answer with its unit (₹, %, units).
What the paper leaves open
The preference dividend is grossed up for tax in the financial break-even point and the indifference level (C5).
Write it in this order
- Read the data; note exactly what is asked 1 min
- 1 EPS under each plan 4 marks 7 min
- 2 Financial break-even points 2 marks 4 min
- 3 Indifference EBIT, with check 4 marks 7 min
- Check: arithmetic, units (₹, %), final answer underlined 1 min
Try it first. About 20 minutes for 10 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.
Interest and preference dividend: Plan A: bonds 9% × 96,000 = ₹8,640; preference 10% × (4,800 × 60 = 2,88,000) = ₹28,800. Plan B: bonds 10% × 1,80,000 = ₹18,000; preference 10% × (2,400 × 70 = 1,68,000) = ₹16,800.
(i) EPS at EBIT of ₹4,80,000 (₹)
| Particulars | Plan A | Plan B |
|---|---|---|
| EBIT | 4,80,000 | 4,80,000 |
| Less: interest on bonds | 8,640 | 18,000 |
| EBT | 4,71,360 | 4,62,000 |
| Less: tax @ 50% | 2,35,680 | 2,31,000 |
| EAT | 2,35,680 | 2,31,000 |
| Less: preference dividend | 28,800 | 16,800 |
| Earnings for common stock | 2,06,880 | 2,14,200 |
| Number of common shares | 24,000 | 27,600 |
| EPS | 8.620 | 7.761 |
(ii) Financial break-even points. Financial break-even EBIT = interest + preference dividend ÷ (1 − t), the preference dividend being paid out of profit after tax (paper note); below it EPS is negative.
- Plan A: 8,640 + 28,800 ÷ 0.5 = ₹66,240
- Plan B: 18,000 + 16,800 ÷ 0.5 = ₹51,600
(iii) Indifference EBIT (equal EPS under both plans):
[(X − 8,640)(0.5) − 28,800] ÷ 24,000 = [(X − 18,000)(0.5) − 16,800] ÷ 27,600
27,600 (0.5X − 33,120) = 24,000 (0.5X − 25,800)
13,800X − 91,41,12,000 = 12,000X − 61,92,00,000
1,800X = 29,49,12,000, so X = ₹1,63,840.
Check. Plan A: (1,55,200 × 0.5 − 28,800) ÷ 24,000 = ₹2.0333; Plan B: (1,45,840 × 0.5 − 16,800) ÷ 27,600 = ₹2.0333. Above ₹1,63,840, Plan A gives the higher EPS (as at ₹4,80,000).
Where the 10 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | EPS under each plan | 4 |
| 2 | Financial break-even points | 2 |
| 3 | Indifference EBIT, with check | 4 |
| Total | 10 |
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