Financial Management study material with illustrations on Financial break-even EBIT, Financial Leverage & EBIT – EPS Solved Questions- Financial leverage has a favorable impact on the EPS only if the ROI is more than the cost of debt. It will rather have an unfavorable effect if the ROI is less than the cost of debt. That is why financial leverage is also called the twin edged sword. It turns out that if the firms after tax borrowing cost, which has denoted as Kd, is less than after tax ROI then increase in financial leverage, holding EBIT constant, will always increase the EPS. A reduction in financial leverage reduces the EPS. If kd, is greater than the ROI then the opposite will occur. These relationships, in fact, follow directly from the accounting relationships and always hold good.
EBIT – EPS Analysis Formulas
If the firm has employed debt only and no preference shares, the financial break-even EBIT level is:
Financial break-even EBIT = Interest Charge
If the firm has employed debt as well as preference share capital, then its financial break-even EBIT will be determined not only by the interest charge but also by the fixed preference dividend. It may be noted that the preference dividend is payable only out of profit after tax, whereas the financial break-even level is before tax. The financial break-even in such a case may be determined as follows:
Financial break-even EBIT = Interest + [(Preference Dividend + Dividend Distribution Tax) ÷ (1 – t)]
The indifference level of EBIT for a given set of financial plans can be ascertained as follows:
1. All-equity financing versus Debt-equity mix:
EPS under All equity financing is:
EPS = [EBIT × (1- t)] ÷ N1
EPS under Debt-equity mix is:
[(EBIT- I) × (1-t)] ÷ N2
I = Total interest charge on debt financing.
N1 = Total No. of Equity shares under financial plan 1
N2 = Total No. of Equity shares under financial plan 2
t = Tax rate.
Since, the EPS is made to be equal under two different plans (for the same EBIT), now setting the two EPS equal to each other-
[EBIT × (1- t)] ÷ N1 = [(EBIT- I) × (1-t)] ÷ N2
The value of EBIT in the above equation is the indifferent level of EBIT for a choice between the all equity financial plan and the debt equity mix financial plan.
2. Debt-equity mix v. Debt-equity mix (different level of debt financing or different rates of interest on debts):
In this case, the indifferent level of EBIT may be ascertained on the same lines as above. Suppose, I1 and I2 are the total interest payments under two different financial plans. Now, the indifference level of EBIT may be ascertained on the basis of the following equation:
[(EBIT- I1) × (1-t)] ÷ N1 = [(EBIT- I2) × (1-t)] ÷ N2
The value of EBIT in this equation is the indifference level of EBIT between two different Debt-equity plans.
(3) All-equity plan v. Equity-preference plan:
In this case, the firm will be required to pay Preference Dividend (PD) also; therefore, indifference level of EBIT may be ascertained as follows:
[EBIT × (1- t)] ÷ N1 = [EBIT × (1- t) – PD] ÷ N2
The value of EBIT in the above equation is indifference level of EBIT between two financial plans i.e., all equity plan and Equity-preference plan.
(4) All-equity plan v. Equity-preference-debt mix:
A firm may be having a situation to make a choice between an all equity plan and the financial mix consisting of equity capital, preference capital and debt. In such a case, the indifference level of EBIT may be ascertained from the following equation:
[EBIT × (1- t)] ÷ N1 = [(EBIT – I) × (1- t) – PD] ÷ N2
1. ABC Ltd. has a current level of EBIT of Rs. 28,00,000 which is likely to be unchanged. It has decided to raise Rs. 5,00,000 of additional capital funds and has identified two mutually exclusive alternative financial plans. The relevant information is as follows:
| Present Capital Structure | 5,00,000 Equity shares of Rs. 10 each, and 10% Bonds of Rs. 30,00,000 |
| Tax rate | 40% |
| Current EBIT | Rs. 28,00,000 |
| Current EPS | Rs. 5 |
| Current market price | Rs. 25 per share |
| Financial Plan I | 40,000 equity shares @ Rs. 25 per share |
| Financial Plan II | 10% debentures of Rs. 10,00,000 |
What is the indifference level of EBIT? What are the financial break-even levels and plot the EBIT-EPS lines on the graph paper. Which alternative financial plan is better?
Solution
If Plan I is accepted, then the new capital structure of the firm is expected to consist of 5,40,000 equity shares and 10% bonds of Rs. 30,00,000. The EPS of the firm in this case would be:
EPSPLAN 1 = [(EBIT- I) × (1-t)] ÷ N1
= [(EBIT- 3,00,000) × (1-0.4)] ÷ 5,40,000
= [0.6 EBIT – 1,80,000] ÷ 5,40,000
I = Total interest charge on debt financing = 10% of Rs. 30,00,000 = Rs. 3,00,000
N1 = Total No. of Equity shares under financial plan 1 = 5,40,000
t = Tax rate.
If Plan II is adopted then the capital structure of the firm would consist of 5,00,000 equity shares, 10% bonds of 30,00,000 and 10% debentures of Rs. 10,00,000. The EPS of the firm in this case would be:
EPSPLAN 2 = [(EBIT- I) × (1-t)] ÷ N1
= [(EBIT- 4,00,000) × (1-0.4)] ÷ 5,00,000
= [0.6 EBIT – 2,40,000] ÷ 5,00,000
I = Total interest charge on debt financing = Rs. 3,00,000 + Rs.1,00,000 = Rs.4,00,000
Interest Calculation:
10% of Rs. 30,00,000 = Rs. 3,00,000
10 % of Rs.10,00,000 = Rs.1,00,000
N2 = Total No. of Equity shares under financial plan 2 = 5,00,000
t = Tax rate.
In order to find out the indifference level of EBIT, EPS under the two plans should be equated as follows:
=> [0.6 EBIT – 1,80,000] ÷ 5,40,000 = [0.6 EBIT – 2,40,000] ÷ 5,00,000
=> 0.6 EBIT – 1,80,000 = [0.6 EBIT – 2,40,000] × 1.08
=> 0.6 EBIT – 1,80,000 = 0.648 EBIT – 2,59,200
=> 0.048 EBIT = 79,200
=> EBIT = 79,200 / 0.048 = Rs. 16,50,000.
So, the value of EBIT at the indifference level is Rs. 16,50,000 and the corresponding values of EPS under both the financial plans would be:
EPSPLAN 1 = [0.6 EBIT – 1,80,000] ÷ 5,40,000
[0.6 × 16,50,000 – 1,80,000] ÷ 5,40,000 = Rs. 1.5
EPSPLAN 2 = [0.6 EBIT – 2,40,000] ÷ 5,00,000
= [0.6 × 16,50,000 – 2,40,000] ÷ 5,00,000 = Rs. 1.5
Financial break–even Levels for these plans:
If the firm has employed debt only and no preference shares, the financial break-even EBIT level is:
Financial break-even EBIT = Interest Charge
Plan I => Financial break-even EBIT = Rs.3,00,000
Plan II => Financial break-even EBIT = Rs. 4,00,000
2. ABC Ltd. is considering a capital structure of Rs. 20,00,000 for which various mutually exclusive set of options are available. Calculate the indifference level of EBIT between the following alternative sets:
I. Equity share capital of Rs. 20,00,000, or 12% Debentures of Rs. 10,00,000 plus equity share capital of Rs. 10,00,000.
II. Equity share Capital of Rs. 20,00,000, or 12% Pref. share Capital of Rs. 10,00,000 plus Equity share capital of Rs. 10,00,000.
III. Equity share capital of Rs. 12,00,000 plus 12% debentures of Rs. 8,00,000 or Equity share capital of Rs. 8,00,000 plus 10% Pref. shares capital of Rs. 4,00,000 plus 12% debenture of Rs. 8,00,000.
IV. Equity share capital of Rs. 16,00,000 plus 10% Pref. shares capital of Rs. 4,00,000, or Equity share capital of Rs. 8,00,000 plus 10 % Pref. shares capital of Rs. 4,00,000 plus 12% debentures of Rs. 8,00,000.
The issue price of equity shares may be taken at par i.e., 100 each and the tax rate may be assumed at 30%. Find out indifference point of EBIT for different sets.
Solution
I. Equity share capital of Rs. 20,00,000, or 12% Debentures of Rs. 10,00,000 plus equity share capital of Rs. 10,00,000.
EPS under All equity financing is:
EPS = [EBIT × (1- t)] ÷ N1
EPS under Debt-equity mix is:
[(EBIT- I) × (1-t)] ÷ N2
Indifference level of EBIT:
=> [EBIT × (1- t)] ÷ N1 = [(EBIT- I) × (1-t)] ÷ N2
=> [EBIT × (1- 0.3)] ÷ 20,000 = [(EBIT- 1,20,000) × (1-.3)] ÷ 10,000
=> 0.7 EBIT ÷ 20,000 = (.7 EBIT – 84,000) ÷ 10,000
0.7 EBIT = (.7 EBIT – 84,000) × 2
=> 0.7 EBIT = 1.4 EBIT – 1,68,000
=> EBIT = 1,68,000 ÷ 0.7 = Rs. 2,40,000
I = Total interest charge on debt financing = Rs.1,20,000
N1 = Total No. of Equity shares under financial plan 1 = 20,000
N2 = Total No. of Equity shares under financial plan 2 = 10,000
t = Tax rate.
II. Equity share Capital of Rs. 20,00,000, or 12% Pref. share Capital of Rs. 10,00,000 plus Equity share capital of Rs. 10,00,000.
All-equity plan v. Equity-preference plan:
In this case, the firm will be required to pay Preference Dividend (PD) also; therefore, indifference level of EBIT may be ascertained as follows:
[EBIT × (1- t)] ÷ N1 = [EBIT × (1- t) – PD] ÷ N2
[EBIT × (1- 0.3)] ÷ 20,000 = [EBIT × (1-.3) – 1,20,000] ÷ 10,000
=> 0.7 EBIT ÷ 20,000 = (.7 EBIT – 1,20,000) ÷ 10,000
0.7 EBIT = (.7 EBIT – 1,20,000) × 2
=> 0.7 EBIT = 1.4 EBIT – 2,40,000
=> EBIT = 2,40,000 ÷ 0.7 = Rs. 3,42,857
PD = Preference Dividend = Rs.1,20,000
N1 = Total No. of Equity shares under financial plan 1 = 20,000
N2 = Total No. of Equity shares under financial plan 2 = 10,000
t = Tax rate.
III. Equity share capital of Rs. 12,00,000 plus 12% debentures of Rs. 8,00,000 or Equity share capital of Rs. 8,00,000 plus 10% Pref. shares capital of Rs. 4,00,000 plus 12% debenture of Rs. 8,00,000.
[(EBIT- I1) × (1-t)] ÷ N1 = [(EBIT – I2) × (1- t) – PD] ÷ N2
=> 0.7 EBIT – 67,200 = 1.5 × (0.7 EBIT – 67,200 – 40,000)
=> 0.7 EBIT – 67,200 = 1.05 EBIT – 1,60,800
=> 0.35 EBIT = 93,600
=> EBIT = Rs. 2,67,428
PD = Preference Dividend = Rs. 40,000
N1 = Total No. of Equity shares under financial plan 1 = 12,000
N2 = Total No. of Equity shares under financial plan 2 = 8,000
t = Tax rate.
I1 = Total interest charge on debt financing = Rs.96,000
I2 = Total interest charge on debt financing = Rs.96,000
IV. Equity share capital of Rs. 12,00,000 plus 10% Pref. shares capital of Rs. 8,00,000, or Equity share capital of Rs. 8,00,000 plus 10 % Pref. shares capital of Rs. 4,00,000 plus 12% debentures of Rs. 8,00,000.
[EBIT × (1-t) – PD1] ÷ N1 = [(EBIT – I) × (1- t) – PD2] ÷ N2
0.7 EBIT – 80,000 = (0.7 EBIT – 67,200 – 40,000) × 1.5
=> 0.7 EBIT – 80,000 = 1.05 EBIT – 1,60,800
=> 0.35 EBIT = 80,800
=> EBIT = Rs. 2,30,857
PD1 = Preference Dividend = Rs. 80,000
PD2 = Preference Dividend = Rs. 40,000
N1 = Total No. of Equity shares under financial plan 1 = 12,000
N2 = Total No. of Equity shares under financial plan 2 = 8,000
t = Tax rate.
I = Total interest charge on debt financing = Rs.96,000
3. The Balance sheet of RBL Company is given below:
| Liabilities | Amount | Assets | Amount |
| Equity Capital (Rs. 10 per Share) | 1,00,000 | Fixed Assets | 2,25,000 |
| Retained Earnings | 40,000 | Current Assets | 75,000 |
| 10% debt | 1,00,000 | ||
| Current Liabilities | 60,000 | ||
| 3,00,000 | 3,00,000 |
The company’s total asset turnover ratio is 4, its fixed operating cost is Rs. 2,50,000 and its variable operating cost ratio is 50%.The income tax rate is 50%.
You are required to calculate:
I. Calculate different type of leverages for the company.
II. Find out EBIT if EPS is: a. Rs. 2 b.Rs.3 c. Rs. 5
Solution
Asset Turnover Ratio = Sales ÷ Total Assets
Sales = 4 × Rs. 3,00,000 = Rs.12,00,000
| Amount (Rs.) | |
| Sales | 12,00,000 |
| Less: Variable Cost (50% of Sales) | (6,00,000) |
| Contribution | 6,00,000 |
| Less: Fixed Operating Cost | (2,50,000) |
| EBIT | 3,50,000 |
| Less : Interest (10% of Rs.1,00,000) | (10,000) |
| EBT | 3,40,000 |
| Less: Tax @ 50 % of EBT | (1,70,000) |
| PAT | 1,70,000 |
| DOL = Contribution ÷ EBIT | 6,00,000 ÷3,50,000 = 1.714 |
| DFL = EBIT ÷ EBT | 3,50,000 ÷3,40,000 = 1.03 |
| DCL = DOL × DFL = Contribution ÷ EBT | 6,00,000÷3,40,000 =1.77 |
II. EBIT at various levels of EPS can be worked out by using following formula:
EPS = [(EBIT- I) × (1-t)] ÷ N
a. 2 = [(EBIT- 10,000) × (1-0.5)] ÷ 10,000
=> 20,000 = 0.5 EBIT – 5,000
EBIT = 25,000 ÷ 0.5 = Rs.50,000
b. 3 = [(EBIT- 10,000) × (1-0.5)] ÷ 10,000
=> 30,000 = 0.5 EBIT – 5,000
EBIT = 35,000 ÷ 0.5 = Rs.70,000
c. 5 = [(EBIT- 10,000) × (1-0.5)] ÷ 10,000
=> 50,000 = 0.5 EBIT – 5,000
EBIT = 55,000 ÷ 0.5 = Rs.1,10,000
4. RBL Manufacturer Ltd. has Equity share capital of Rs. 5,00,000 (face value Rs. 100). To meet the expenditure of an expansion program, the company wishes to raise Rs. 3,00,000 and is having following four alternative sources to raise the funds:
Plan A: To have full money from the issue of Equity Shares.
Plan B: To have Rs. 1,00,000 from Equity and Rs. 2,00,000 from borrowings from the financial institutions @10% per annum.
Plan C: Full money from borrowings @ 10% per annum.
Plan D: Rs. 1,00,000 in Equity and Rs. 2,00,000 from 10 % Preference shares.
The company is having present earnings of Rs.2,00,000. The corporate tax is 50%. Select a suitable plan out of the four plans to raise the required funds.
Solution
| Plan A | Plan B | Plan C | Plan D | |
| EBIT | 2,00,000 | 2,00,000 | 2,00,000 | 2,00,000 |
| Less: Int. | ______ | (20,000) | (30,000) | _____ |
| EBT | 2,00,000 | 1,80,000 | 1,70,000 | 2,00,000 |
| Less: Tax @ 50 % | (1,00,000) | (90,000) | (85,000) | (1,00,000) |
| PAT | 1,00,000 | 90,000 | 85,000 | 1,00,000 |
| Less: P.D. | ______ | ______ | ______ | (20,000) |
| EAS | 1,00,000 | 90,000 | 85,000 | 80,000 |
| No. of Shares | 8,000 | 6,000 | 5,000 | 6,000 |
| EPS = EAS ÷ No. of Shares | 12.5 | 15 | 17 | 13.33 |
EAS = Earnings available for Equity Shareholders
Since maximum EPS is of Plan C, hence Plan C should be accepted.
5. The existing capital structure of ABC L.td. is as follows:
| Equity shares of Rs.100 each | Rs. 40,00,000 |
| Retained earnings | Rs. 10,00,000 |
| 9% Preference Shares | Rs. 25,00,000 |
| 10 % Debentures | Rs. 25,00,000 |
| Total | 1,00,00,000 |
The company earns a return (EBIT) of 10 % and the tax on income is 50%.
The company wants to raise Rs. 30,00,000 for its expansion project for which it is considering following alternatives:
i. Issue of 24,000 Equity shares at a premium of Rs. 25 per share.
ii. Issue of 8 % Preference Shares.
iii. Issue of 10% Debentures.
It is projected that P/E ratios in case of Equity, Preference and Debenture financing shall be 20, 17 and 16 respectively.
Solution
Existing Capital = Rs. 1,00,00,000
Additional Capital to be raised = Rs.30,00,000
Total Capital = Rs. 1,30,00,000
EBIT = 10 % 0f Rs. 1,30,00,000 = Rs. 13,00,000
| Option I | Option II | Option III | |
| EBIT | 13,00,000 | 13,00,000 | 13,00,000 |
| Less: Int. | (2,50,000) | (2,50,000) | (5,50,000) |
| EBT | 10,50,000 | 10,50,000 | 7,50,000 |
| Less: Tax @ 50% | (5,25,000) | (5,25,000) | (3,75,000) |
| PAT | 5,25,000 | 5,25,000 | 3,75,000 |
| Less: PD | (2,25,000) | (4,65,000) | (2,25,000) |
| EAS | 3,00,000 | 60,000 | 1,50,000 |
| No. of Equity Shares | 64,000 | 40,000 | 40,000 |
| EPS = EAS ÷ No. of Shares | 4.69 | 1.5 | 3.75 |
EAS = Earnings available for Equity Shareholders
Option I (Equity financing) is best because the MP of Equity is expected highest in this case and EPS is maximum.
6. A Ltd. has a share capital of Rs. 10,00,000 divided into share of Rs. 100 each. It has a major expansion program requiring an investment of another Rs. 5,00,000. The management is considering the following alternatives for raising this amount:
i. Issue of 5,000 equity shares of Rs. 100 each.
ii. Issue of 5,000, 10% preference shares of Rs. 100 each.
iii. Issue of 10% debentures of Rs. 5,00,000.
The company’s present earnings before interest and tax (EBIT) are Rs. 4,00,000 per annum subject to tax at 50%. You are required to calculate the effect of each of the above financial plan on the earnings per share presuming:
a. EBIT continues to be the same even after expansion.
b. EBIT increases by Rs.1,00,000.
Solution
Case a:
| Option I | Option II | Option III | |
| EBIT | 4,00,000 | 4,00,000 | 4,00,000 |
| Less: Int. | ——- | —– | (50,000) |
| EBT | 4,00,000 | 4,00,000 | 3,50,000 |
| Less: Tax @ 50% | (2,00,000) | (2,00,000) | (1,75,000) |
| PAT | 2,00,000 | 2,00,000 | 1,75,000 |
| Less: PD | —— | (50,000) | ——- |
| EAS | 2,00,000 | 1,50,000 | 1,75,000 |
| No. of Equity Shares | 15,000 | 10,000 | 10,000 |
| EPS = EAS ÷ No. of Shares | 13.33 | 15 | 17.5 |
Case b:
| Option I | Option II | Option III | |
| EBIT | 5,00,000 | 5,00,000 | 5,00,000 |
| Less: Int. | ——- | —– | (50,000) |
| EBT | 5,00,000 | 5,00,000 | 4,50,000 |
| Less: Tax @ 50% | (2,50,000) | (2,50,000) | (2,25,000) |
| PAT | 2,50,000 | 2,50,000 | 2,25,000 |
| Less: PD | —— | (50,000) | ——- |
| EAS | 2,50,000 | 2,00,000 | 2,25,000 |
| No. of Equity Shares | 15,000 | 10,000 | 10,000 |
| EPS = EAS ÷ No. of Shares | 16.67 | 20 | 22.5 |
Under both assumptions of EBIT, the EPS would be highest in Plan II.
7. A company needs Rs. 12,00,000 for the installation of a new factory which is expected to earn an EBIT of Rs. 2,50,000 per annum. The company has the objective of maximizing the earnings per share. It is considering the possibility of issuing equity shares plus raising a debt of Rs. 2,00,000 or Rs. 6,00,000 or Rs. 10,00,000. The current market price of the share is Rs. 50 and will drop to Rs. 40 if the borrowings exceed Rs. 7,50,000. The costs of borrowing are indicated as under:
| Up to Rs. 2,50,000 | 10% |
| Rs. 2,50,000 – Rs. 6,25,000 | 15% |
| Rs. 6,25,000 – Rs. 10,00,000 | 18% |
Assuming the tax rate to be 50%, find out the EPS under different options.
Solution
| Option I | Option II | Option III | |
| Fund needed | 12,00,000 | 12,00,000 | 12,00,000 |
| Debt funding | 2,00,000 | 6,00,000 | 10,00,000 |
| Equity Funding | 10,00,000 | 6,00,000 | 2,00,000 |
| Issue Price of Equity Share | 50 | 50 | 40 |
| No. of Equity Shares | 20,000 | 12,000 | 5,000 |
| Interest Calculation: | |||
| 10 % of 2,00,000 | 20,000 | ||
| 15 % of 6,00,000 | 90,000 | ||
| 18 % of 10,00,000 | 1,80,000 | ||
| EBIT | 2,50,000 | 2,50,000 | 2,50,000 |
| Less: Interest | (20,000) | (90,000) | (1,80,000) |
| EBT | 2,30,000 | 1,60,000 | 70,000 |
| Less: Tax @ 50% of EBT | (1,15,000) | (80,000) | (35,000) |
| PAT | 1,15,000 | 80,000 | 35,000 |
| No. of Shares | 20,000 | 12,000 | 5,000 |
| EPS = PAT ÷ No. of Shares | Rs. 5.75 | Rs. 6.67 | Rs. 7 |
8.RBL Ltd. is considering three different plans to finance its total project costs of Rs. 100 lacs. These are
| Amount in Lacs | |||
| Plan A | Plan B | Plan C | |
| Equity (Rs.100 per share) | 50 | 35 | 25 |
| 10 % Debentures | 50 | 65 | 75 |
| 100 | 100 | 100 |
Sales for the first three years of operations are estimated at Rs.120 lacs, Rs. 130 lacs and Rs. 150 lacs and a 10% profit before interest and taxes is forecasted to be achieved & corporate taxation to be taken at 50%. Compute earnings per share in each of the alternative plans of financing for the three years and evaluate the proposals.
Solution
| PLAN A | Year 1 | Year 2 | Year 3 |
| EBIT | 12,00,000 | 13,00,000 | 15,00,000 |
| Less: Interest | (5,00,000) | (5,00,000) | (5,00,000) |
| EBT | 7,00,000 | 8,00,000 | 10,00,000 |
| Less: Tax @ 50% | (3,50,000) | (4,00,000) | (5,00,000) |
| PAT | 3,50,000 | 4,00,000 | 5,00,000 |
| No. of Shares | 50,000 | 50,000 | 50,000 |
| EPS = PAT ÷ No. of Shares | 7 | 8 | 10 |
| PLAN B | Year 1 | Year 2 | Year 3 |
| EBIT | 12,00,000 | 13,00,000 | 15,00,000 |
| Less: Interest | (6,50,000) | (6,50,000) | (6,50,000) |
| EBT | 5,50,000 | 6,50,000 | 8,50,000 |
| Less: Tax @ 50% | (2,75,000) | (3,25,000) | (4,25,000) |
| PAT | 2,75,000 | 3,25,000 | 4,25,000 |
| No. of Shares | 35,000 | 35,000 | 35,000 |
| EPS = PAT ÷ No. of Shares | 7.86 | 9.29 | 12.14 |
| PLAN C | Year 1 | Year 2 | Year 3 |
| EBIT | 12,00,000 | 13,00,000 | 15,00,000 |
| Less: Interest | (7,50,000) | (7,50,000) | (7,50,000) |
| EBT | 4,50,000 | 5,50,000 | 7,50,000 |
| Less: Tax @ 50% | (2,25,000) | (2,75,000) | (3,75,000) |
| PAT | 2,25,000 | 2,75,000 | 3,75,000 |
| No. of Shares | 25,000 | 25,000 | 25,000 |
| EPS = PAT ÷ No. of Shares | 9 | 11 | 15 |
9. A firm is considering alternative proposals to finance its expansion plan of Rs. 5,00,000. Two such proposals are:
i. Issue of 10 % loans of Rs.2,50,000 and issue of 2,500 equity shares of Rs. 100 each, and
ii. Issue of 5,000 equity shares of Rs.100 each.
Given the tax rate at 50%, and assuming EBIT of Rs. 1,00,000 and Rs. 1,20,000, which alternative is better? Also compute the indifference level of EBIT of the two financial plans.
Solution
| Plan I | Plan I | Plan II | Plan II | |
| EBIT | 1,00,000 | 1,20,000 | 1,00,000 | 1,20,000 |
| Less: Interest | (25,000) | (25,000) | ——— | ——- |
| EBT | 75,000 | 1,05,000 | 1,00,000 | 1,20,000 |
| Less: Tax @ 50% | (37,500) | (52,500) | (50,000) | (60,000) |
| PAT | 37,500 | 52,500 | 50,000 | 60,000 |
| No. of Shares | 2,500 | 2,500 | 5,000 | 5,000 |
| EPS = PAT ÷ No. of Shares | 15 | 21 | 10 | 12 |
EPS of option I i.e. mix of debt and equity has higher EPS under both EBITs. Hence option I should be opted.
Indifference level of EBZIT under both plans will be-
=> [EBIT × (1- t)] ÷ N1 = [(EBIT- I) × (1-t)] ÷ N2
=> [(EBIT – 25,000) × (1-0.3)] / 2500 = [EBIT × (1-0.3)] / 5,000
=> (0.7 EBIT – 17,500) / 2,500 = 0.7 EBIT / 5,000
=>1.4 EBIT – 35,000 = 0.7 EBIT
=> 0.7 EBIT = 35,000
=> EBIT = 35,000 / 0.7 = Rs.50,000
10. Anew project under consideration requires a capital outlay of Rs. 5,000,00 for which the funds can either be raised by the issue of equity shares of Rs.100 each or by the issue of equity shares of the value of Rs.2,00,000 and by the issue of 15% loan of Rs. 3,00,000, Find out the indifference level of EBIT given the tax rate at 30 %.
Solution
Indifference level of EBIT:
=> [EBIT × (1- t)] ÷ N1 = [(EBIT- I) × (1-t)] ÷ N2
=> [EBIT × (1- 0.3)] ÷ 5,000 = [(EBIT- 45,000) × (1-.3)] ÷ 2,500
=> 0.7 EBIT / 2 = 0.7 EBIT – 31,500
=> 0.7 EBIT = 63,000
=> EBIT = 63,000 / 7 = Rs.90,000
N1 = no. of equity shares under first financing option = 5,000.
N2 = no. of equity shares under second financing option = 2,500.
11. The following data pertains to RBL Limited:
Existing capital structure: 1,00,000 Equity Shares of Rs. 100 each.
Tax Rate: 50 per cent
RBL Limited plans to raise additional capital of Rs. 5,00,00,000 for financing an expansion project. It is evaluating two alternative financing plans: (i) Issue of 5,00,000 equity shares of Rs. 100 each and (ii) Issue of Rs. 5,00,00,000 debentures carrying 14% interest.
You are required to compute indifference point.
Solution
Indifference level of EBIT:
=> [EBIT × (1- t)] ÷ N1 = [(EBIT- I) × (1-t)] ÷ N2
=> [EBIT × (1- 0.5)] ÷ 6,00,000 = [(EBIT- 70,00,000) × (1-.5)] ÷ 1,00,000
=> 0.5 EBIT = 6 × (0.5 EBIT – 35,00,000)
=> 2.5 EBIT = 2,10,00,000
=> EBIT = 2,10,00,000 / 2.5 = Rs.84,00,000.
N1 = no. of equity shares under first financing option = 6,00,000.
N2 = no. of equity shares under second financing option = 1,00,000.
12. RBL Ltd. is considering a major expansion of its production facilities and wants to raise Rs. 50 lakh for the purpose. The following alternatives are available to raise the required amount:
| Sources | Alternatives | ||
| A | B | C | |
| Equity Share Capital | 50 | 15 | 10 |
| 10% Debentures | _____ | 20 | 15 |
| 15% Preference Share Capital | _____ | 15 | 25 |
Expected Earnings before interest and taxes is 25% of investment. The corporate tax rate is 50%. At present the company has no debt. Which of the alternative would you choose if the objective of the firm is to maximise the rate of return on Equity Capital?
Solution
| Option A | Option B | Option C | |
| Investment | 50,00,000 | 50,00,000 | 50,00,000 |
| Rate of Return | 20% | 20% | 20% |
| EBIT | 10,00,000 | 10,00,000 | 10,00,000 |
| Less: Int. | ————– | (2,00,000) | (1,50,000) |
| EBT | 10,00,000 | 8,00,000 | 8,50,000 |
| Less: Tax @ 50% | (5,00,000) | (4,00,000) | (4,25,000) |
| PAT | 5,00,000 | 4,00,000 | 4,25,000 |
| Less: PD | ————- | (2,25,000) | (3,75,000) |
| EAS | 5,00,000 | 1,75,000 | 50,000 |
| Equity Share | 50,00,000 | 15,00,000 | 10,00,000 |
| Return on Equity Share Capital = ( EAS ÷Equity Share Capital) ×100 | 10% | 11.67% | 5% |
Alternative B is better if the objective of the firm is to maximise the rate of return on Equity Capital.
13. From the following information available for 4 firms, calculate EBIT, EPS, Operating leverage and Financial leverage:
| Firm | A | B | C | D |
| Sales (in Units) | 20,000 | 25,000 | 30,000 | 40,000 |
| Selling price per unit (Rs.) | 15 | 20 | 25 | 30 |
| Variable cost per unit | 10 | 15 | 20 | 25 |
| Fixed costs | 15,000 | 40,000 | 50,000 | 60,000 |
| Interest | 30,000 | 25,000 | 35,000 | 40,000 |
| Tax % | 50 | 50 | 50 | 50 |
| Number of equity shares | 5,000 | 9,000 | 10,000 | 12,000 |
Solution
| Firm | A | B | C | D |
| Sales (in Units) | 20,000 | 25,000 | 30,000 | 40,000 |
| Selling price per unit (Rs.) | 15 | 20 | 25 | 30 |
| Sales | 3,00,000 | 5,00,000 | 7,50,000 | 12,00,000 |
| Variable cost (VC) per unit | 10 | 15 | 20 | 25 |
| Less: VC | (2,00,000) | (3,75,000) | (6,00,000) | (10,00,000) |
| Contribution | 1,00,000 | 1,25,000 | 1,50,000 | 2,00,000 |
| Less: Fixed costs | (15,000) | (40,000) | (50,000) | (60,000) |
| EBIT | 85,000 | 85,000 | 1,00,000 | 1,40,000 |
| Less: Interest | (30,000) | (25,000) | (35,000) | (40,000) |
| EBT | 55,000 | 60,000 | 65,000 | 1,00,000 |
| Tax @ 50% | (27,500) | (30,000) | (32,500) | (50,000) |
| PAT | 27,500 | 30,000 | 32,500 | 50,000 |
| Number of equity shares | 5,000 | 9,000 | 10,000 | 12,000 |
| EPS = PAT÷ Number of equity shares | 5.5 | 3.33 | 3.25 | 4.17 |
| Operating Leverage = C/EBIT | 1.18 | 1.18 | 1.5 | 1.43 |
| Financial Leverage = EBIT/EBT | 1.55 | 1.42 | 1.54 | 1.4 |
14. MC Ltd. is planning an expansion program which will require Rs. 50 crores and can be funded through one of the three following options:
1. Issue further equity shares of Rs. 100 each at par,
2. Raise a 10% loan, and
3. Issue 10% preference shares.
The present paid up capital is Rs. 60 crores and the annual EBIT is Rs. 12 crores. The tax rate may be taken at 50%. After the expansion plan is adopted, the EBIT is expected to be Rs.25 crores.
Calculate the EPS under all the three financing options indicating the alternative giving the highest return to the equity shareholders. Also determine the indifference point between the equity share capital and the debt financing (i.e., option 1 and option 2 above).
Solution
| Amount in Crore | |||
| Firm | Option 1 | Option 2 | Option 3 |
| EBIT | 25 | 25 | 25 |
| Less: Interest | —– | (5) | —- |
| EBT | 25 | 20 | 25 |
| Tax @ 50% | (12.5) | (10) | (12.5) |
| PAT | 12.5 | 10 | 12.5 |
| Less: PD | —- | —- | (5) |
| EAS | 12.5 | 10 | 7.5 |
| Number of equity shares | 1.1 | .6 | .6 |
| EPS = EAS÷ Number of equity shares | Rs. 11.36 | Rs.16.67 | Rs.12.5 |
Indifference level of EBIT:
=> [EBIT × (1- t)] ÷ N1 = [(EBIT- I) × (1-t)] ÷ N2
=> [EBIT × (1- 0.5)] ÷ 1,10,00,000 = [(EBIT- 5,00,00,000) × (1-.5)] ÷ 60,00,000
=>0.5 EBIT = 1.8333 × (0.5 EBIT – 2,50,00,000)
0.92 EBIT – 0.5 EBIT = 4,58,33,250
EBIT = Rs. 10,91,26,785
15. Calculate EPS of A Ltd. and B Ltd. assuming (a) 20% Before Tax return on Assets, (b) 10% Before Tax return on Assets on the basis of the following data.
| A Ltd | B Ltd | |
| Total Assets | 1,20,00,000 | 1,20,00,000 |
| Equity Share Capital of Rs.100 each | 1,20,00,000 | 60,00,000 |
| 12 % Debt | ——- | 60,00,000 |
Comment on the Financial Leverage of the firm assuming tax rate of 50%.
Solution
Total Asset return =>
10% of Rs. 1,20,00,000 = Rs.12,00,000
20% of Rs. 1,20,00,000 = Rs.24,00,000
| Firm | A Ltd | B Ltd | ||
| EBIT | 24,00,000 | 12,00,000 | 24,00,000 | 12,00,000 |
| Less: Interest | — | — | (7,20,000) | (7,20,000) |
| EBT | 24,00,000 | 12,00,000 | 16,80,000 | 4,80,000 |
| Tax @ 50% | (12,00,000) | (6,00,000) | (8,40,000) | (2,40,000) |
| PAT | 12,00,000 | 6,00,000 | 8,40,000 | 2,40,000 |
| Number of equity shares | 1,20,000 | 1,20,000 | 60,000 | 60,000 |
| EPS = EAS÷ Number of equity shares | 10 | 5 | 14 | 4 |
A Ltd. does not have any financial leverage as there is no debt. So, the 50% decrease in EBIT (from 20% to 10%) result in decrease in EPS also by 50% (from 10 to Rs.5). In case of B Ltd., there is 50% leverage. For a decrease of 50% in EBIT from 20% to 10%, the EPS also decreases from Rs. 14 to Rs.4 (i.e. a decrease of 71.4%). The financial leverage of firm B at 20% return level is:
Financial Leverage = EBIT ÷ EBT
= 24,00,000 ÷ 16,80,000 = 1.42857
=> So, for 50% decrease in EBIT, the EPS would fall by
.50 X 1.42857 = .7142 or 71.42%.
16. POR Ltd. provides the following details:
| Installed Capacity | 1,50,000 units |
| Actual Production and Sales | 1,20,000 units |
| Selling Price per unit | Re. 1 |
| Variable Cost per unit | Re. 0.50 |
| Fixed Cost | 40,000 |
| Funds required | Rs. 1,00,000 |
| Capital Structure | Financial Plans | ||
| A | B | C | |
| Equity shares of Rs. 100 each to be issued at 25% Premium | 60% | 40% | 35% |
| 10 % Debt | 40% | 60% | 50% |
| 12% preference shares of 100 each | ——- | —— | 15% |
Assume Income Tax rate 50%.
Calculate:
(i) Degree of Operating Leverage, Financial Leverage and
Combined Leverage for each financial plan.
(ii) The Indifference point between Plan A and B.
(iii) The Financial break-even point for each plan and suggest which plan has more financial risk.
Solution
| Plan A | Plan B | Plan C | |
| Sales | 1,20,000 | 1,20,000 | 1,20,000 |
| Less: Variable Cost (50% of Sales) | (60,000) | (60,000) | (60,000) |
| Contribution | 60,000 | 60,000 | 60,000 |
| Less: Fixed Cost | (40,000) | (40,000) | (40,000) |
| EBIT | 20,000 | 20,000 | 20,000 |
| Less : Interest | (4,000) | (6,000) | (5,000) |
| EBT | 16,000 | 14,000 | 15,000 |
| Less: Tax @ 50 % of EBT | (8,000) | (7,000) | (7,500) |
| PAT | 8,000 | 7,000 | 7,500 |
| Less: P.D. | —— | —– | (1,800) |
| EAS | 8,000 | 7,000 | 5,700 |
| No. of Equity Shares | 480 | 320 | 280 |
| EPS = EAS ÷ No. of Equity Shares | 16.67 | 21.875 | 20.36 |
| DOL = Contribution ÷ EBIT | 3 | 3 | 3 |
| DFL = EBIT ÷ EBT | 1.25 | 1.43 | 1.33 |
| DCL = DOL × DFL = Contribution ÷ EBT | 3.75 | 4.29 | 3.99 |
Indifference Point between Plan A and B:
=> [(EBIT- I1) × (1-t)] ÷ N1 = [(EBIT- I2) × (1-t)] ÷ N2
=> [(EBIT- 4,000) × (1-0.5)] ÷ 480 = [(EBIT- 6,000) × (1-0.5)] ÷ 320
=> (0.5 EBIT – 2,000) ÷ 480 = (0.5 EBIT – 3,000) ÷ 320
=> (0.5 EBIT – 2,000) = (0.5 EBIT – 3,000) × 1.5
=> 0.25 EBIT = 2,500
=> EBIT = 2,500 ÷ 0.25 = Rs.10,000
(iii) Financial Break-even level of EBIT:
Plan A: Interest charges =Rs. 4,000
Plan B: Interest charges =Rs. 6,000
Plan C: Interest + [PD ÷ (1- t )]
=> 5,000 + [1,800 ÷0.5] = Rs.8,600
17. Following information is available in respect of RBL Ltd.
| Equity Share Capital of Rs.10 each | 25,00,000 |
| 10% Debentures | 45,00,000 |
| Fixed Cost | 4,10,000 |
| Operating Leverage | 1.4 |
| Combined Leverage | 2.8 |
| Sales | 60,00,000 |
| Tax rate | 50% |
Find out the Financial Leverage and EPS of the firm.
Solution
Financial Leverage = Combined Leverage ÷ Operating Leverage => 2.8 ÷ 1.4 = 2
Operating Leverage = Contribution ÷ EBIT
1.4 = Contribution ÷ (Contribution – Fixed Cost)
1.4 Contribution – 1.4 Fixed Cost = Contribution
=> 0.4 Contribution = 1.4 × Rs.4,10,000 = Rs.5,74,000
=>0.4 Contribution = Rs.5,74,000
=> Contribution = Rs.5,74,000 / 04 = Rs.14,35,000
PAT = (Contribution – Fixed Cost – Interest) × (1- t)
= (Rs.14,35,000 – Rs.4,10,000 – Rs.4,50,000)× 0.5
= Rs. 2,87,500
EPS = PAT / no. of equity shares
= Rs. 2,87,500 / 2,50,000 = Rs.1.15
18. A new project is under consideration in XYZ Ltd., which requires a capital investment of Rs. 6 Crore. Interest on Term loan is 12% and corporate tax is 50%. If the Debt – Equity ratio insisted by the financing agencies is 2:1, calculate the point of indifference for the project.
Solution
In the given case, the indifference level of EBIT will be calculated between loan option (given) and the equity option (implied):
Loan Option:
Total funds = Rs.6,00,00,000
Debt-Equity Ratio 2:1
So, 12% Debt = Rs.4,00,00,000
Equity (FV = Rs. 10 each) = Rs.6,00,00,000
Equity Option:
Equity (FV = Rs. 10 each) = Rs.6,00,00,000
Indifference Level of EBIT:
[EBIT × (1- t)] ÷ N1 = [(EBIT- I) × (1-t)] ÷ N2
=> 0.5 EBIT ÷ N1 = [0.5 EBIT – 0.5 × 48,00,000] ÷ 20,00,000
=> 0.5 EBIT ÷ 60,00,000 = [0.5 EBIT – 24,00,000] ÷ 20,00,000
=> 0.5 EBIT = 1.5 EBIT – 72,00,000
EBIT = Rs.72,00,000
19. Following is the Balance Sheet of RBL Equipment Ltd.:
| Capital & Liabilities | Amount | Assets | Amount |
| Equity Share Capital of Rs.10 each) | 70,000 | Fixed Assets | 1,50,000 |
| Reserves | 20,000 | Current Assets | 1,00,000 |
| 10% Debt | 80,000 | ||
| Current Liabilities | 80,000 | ||
| 2,50,000 | 2,50,000 |
The Fixed Assets turnover of the firm is 4. Fixed Operating Cost of the firm is Rs.1,00,000 and variable cost is 50 %. The tax rate is 50%. Find out-
i. Different leverages for the firm.
ii. Likely level of EBIT if EPS is Rs. 25
iii. Financial Break-even level.
Solution
Total Asset Turnover Ratio = Sales / Total Assets
Sales = Rs.2,50,000 × 4 = Rs.10,00,000
| Sales | 10,00,000 |
| Less: Variable Cost (50% of Sales) | (5,00,000) |
| Contribution | 5,00,000 |
| Less: Fixed Cost | (1,00,000) |
| EBIT | 4,00,000 |
| Less : Interest | (8,000) |
| EBT | 3,92,000 |
| Less: Tax @ 50 % of EBT | (1,96,000) |
| PAT | 1,96,000 |
| No. of Equity Shares | 7,000 |
| EPS = EAS ÷ No. of Equity Shares | 28 |
| DOL = Contribution ÷ EBIT | 1.25 |
| DFL = EBIT ÷ EBT | 1.02 |
| DCL = DOL × DFL = Contribution ÷ EBT | 1.28 |
Calculation of Desired Level of EBIT:
EPS = [(EBIT – I) × (1- t)] ÷ N
=> 25 = [(EBIT – 8,000) × (1- 0.5)] ÷ 7,000
=> 1,75,000 = 0.5 EBIT – 4,000
=> EBIT = 179,000 / 0.5 = Rs.3,58,000
Financial Break-Even Level:
Financial Break-Even level is that level of EBIT at which EPS is 0.
For EPS = 0
EPS = [(EBIT – I) × (1- t)] ÷ N
=> 0 = [(EBIT – 8,000) × (1- 0.5)] ÷ 7,000
=> 0 = 0.5 EBIT – 4,000
=> EBIT = Rs.8,000
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