Question 3 (a)
EBIT indifference: all equity versus 2:1 debt and equity
8 marks
- Time to write
- About 16 minutes
From an older CBCS paper
Question
Question 3 (a) · 8 marks- RK Industries Ltd. is setting up a project that needs a capital expenditure of ₹96,00,000, and is considering two options to finance it:
Option 1: Equity Finance, 100%
Option 2: Debt and Equity, in 2:1 ratio
An Equity share has a face value of ₹10. Interest on debt is payable at 18% p.a., and the corporate tax rate is 40% p.a. At what EBIT level will RK Industries be indifferent between the two financing options?
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
Write it in this order
- Read the data; note exactly what is asked 1 min
- 1 Shares and interest under each option 2 marks 3 min
- 2 Indifference equation and EBIT 4 marks 7 min
- 3 Check and interpretation 2 marks 3 min
- Check: arithmetic, units (₹, %), final answer underlined 2 min
Short on time? Step 2 carries 4 of the 8 marks: guard its minutes.
Try it first. About 16 minutes for 8 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.
The plans. Capital needed ₹96,00,000; shares of ₹10; debt at 18%; tax 40%.
| Particulars | Option 1: equity | Option 2: debt and equity 2:1 |
|---|---|---|
| Equity (₹) | 96,00,000 | 32,00,000 |
| Debt (₹) | — | 64,00,000 |
| Number of shares | 9,60,000 | 3,20,000 |
| Interest @ 18% (₹) | — | 11,52,000 |
Indifference point. The EBIT at which both options give the same EPS, found by equating their EPS. With X the EBIT:
X(1 − 0.40) ÷ 9,60,000 = (X − 11,52,000)(1 − 0.40) ÷ 3,20,000
3,20,000X = 9,60,000(X − 11,52,000), so 6,40,000X = 11,05,92,00,00,000 and X = ₹17,28,000.
Check. At EBIT ₹17,28,000: option 1 EPS = 17,28,000 × 0.6 ÷ 9,60,000 = ₹1.08; option 2 EPS = (17,28,000 − 11,52,000) × 0.6 ÷ 3,20,000 = ₹1.08.
Above ₹17.28 lakh of EBIT, option 2 (with debt) gives the higher EPS; below it, option 1 does.
Where the 8 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Shares and interest under each option | 2 |
| 2 | Indifference equation and EBIT | 4 |
| 3 | Check and interpretation | 2 |
| Total | 8 |
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