Question 3 (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 3 (b) · 10 marksKLM Ltd. is evaluating two plans of financing. Assuming a tax rate of 50% and an expected EBIT of Rs. 750000, determine from the data below
The EPS under each plan,
Each plan's financial break even points,
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 100000 at 10% | Rs 187500 at 10% |
| 10% Preference stock | 10000 shares of Rs 30 | 5000 shares of Rs 40 each |
| Common stocks | 25000 shares | 30000 shares |
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
- Assuming a tax rate of 50%…The paper fixes this: use it as given, and say so in your answer.
- determineFormula first, then the working, then the answer with its unit (₹, %, units).
Write it in this order
- Read the data; note exactly what is asked 1 min
- 1 Interest and preference dividend under each plan 1 mark 2 min
- 2 EPS under each plan 3 marks 5 min
- 3 Financial break-even points 2 marks 4 min
- 4 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 10% of 1,00,000 = ₹10,000; preference 10% of (10,000 × ₹30 = 3,00,000) = ₹30,000. Plan B: bonds 10% of 1,87,500 = ₹18,750; preference 10% of (5,000 × ₹40 = 2,00,000) = ₹20,000.
(i) EPS at EBIT of ₹7,50,000 (₹)
| Particulars | Plan A | Plan B |
|---|---|---|
| EBIT | 7,50,000 | 7,50,000 |
| Less: interest on bonds | 10,000 | 18,750 |
| EBT | 7,40,000 | 7,31,250 |
| Less: tax @ 50% | 3,70,000 | 3,65,625 |
| EAT | 3,70,000 | 3,65,625 |
| Less: preference dividend | 30,000 | 20,000 |
| Earnings for common stockholders | 3,40,000 | 3,45,625 |
| Number of common shares | 25,000 | 30,000 |
| EPS | 13.60 | 11.52 |
(ii) Financial break-even points. The financial break-even EBIT is the EBIT that just covers the fixed financial charges; with preference shares it is interest + preference dividend ÷ (1 − t), because preference dividend is paid out of profit after tax. Below it, EPS is negative.
- Plan A: 10,000 + 30,000 ÷ 0.5 = ₹70,000
- Plan B: 18,750 + 20,000 ÷ 0.5 = ₹58,750
(iii) Indifference level of EBIT. It is the EBIT at which both plans give the same EPS:
[(X − 10,000)(1 − 0.5) − 30,000] ÷ 25,000 = [(X − 18,750)(1 − 0.5) − 20,000] ÷ 30,000
30,000 (0.5X − 35,000) = 25,000 (0.5X − 29,375)
15,000X − 105,00,00,000 = 12,500X − 73,43,75,000
2,500X = 31,56,25,000, so X = ₹1,26,250.
Check. At EBIT ₹1,26,250: Plan A EPS = (1,16,250 × 0.5 − 30,000) ÷ 25,000 = ₹1.125; Plan B EPS = (1,07,500 × 0.5 − 20,000) ÷ 30,000 = ₹1.125. Above ₹1,26,250 Plan A gives the higher EPS (as at ₹7,50,000), below it Plan B.
Where the 10 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Interest and preference dividend under each plan | 1 |
| 2 | EPS under each plan | 3 |
| 3 | Financial break-even points | 2 |
| 4 | Indifference EBIT, with check | 4 |
| Total | 10 |
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