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Tuesday, August 17, 2021

EBIT - EPS Analysis - Financial Break Even EBIT, Indifference Level of EBIT Solved Problems - BBA, B.Com, MBA, CA, CS, CMA, UGC NET & UPSC Financial Management Notes

Links to Financial Management notes: -

Time Value of Money

https://rblacademy.blogspot.com/2021/06/time-value-of-money-formulae-financial.html

https://rblacademy.blogspot.com/2021/06/time-value-of-money-part-i-solved.html

https://rblacademy.blogspot.com/2021/06/time-value-of-money-part-2-solved.html

https://rblacademy.blogspot.com/2021/06/time-value-of-money-part-3-solved.html

https://rblacademy.blogspot.com/2021/05/time-value-of-money-i-financial.html

Leverage Analysis

https://rblacademy.blogspot.com/2021/08/financial-management-notes-leverage.html

Cost of Capital

https://rblacademy.blogspot.com/2021/08/cost-of-capital-solved-problems.html

EBIT – EPS Analysis

https://rblacademy.blogspot.com/2021/08/ebit-eps-analysis-financial-break-even.html

Capital Structure Analysis

https://rblacademy.blogspot.com/2022/02/capital-structure-theories-solved.html

Planning & Designing of Capital Structure

https://rblacademy.blogspot.com/2022/03/planning-designing-of-capital-structure.html

Estimation of Cash Flow in Capital Budgeting

https://rblacademy.blogspot.com/2021/06/part-1-estimation-of-cash-flow-in.html

https://rblacademy.blogspot.com/2021/06/part-2-estimation-of-cash-flow-in.html

https://rblacademy.blogspot.com/2021/06/part-3-estimation-of-cash-flow-in.html

https://rblacademy.blogspot.com/2022/03/estimation-of-cash-flow-in-capital.html

Techniques of Capital Budgeting

https://rblacademy.blogspot.com/2021/05/techniques-of-capital-budgeting.html

https://rblacademy.blogspot.com/2021/05/capital-budgeting-i-httprblacademycom.html

https://rblacademy.blogspot.com/2021/05/financial-management-capital-budgeting.html

https://rblacademy.blogspot.com/2021/06/techniques-of-capital-budgeting-solved_2.html

https://rblacademy.blogspot.com/2021/06/techniques-of-capital-budgeting-solved_14.html

https://rblacademy.blogspot.com/2021/06/techniques-of-capital-budgeting-solved.html

EBIT – EPS Analysis

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 K_d, 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 k_d, 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:

EPS_PLAN
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:

EPS_PLAN
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

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)/(5,40,000) = (0.6 EBIT – 2,40,000)/(5,00,000) => (0.6 EBIT – 1,80,000)/(0.6 EBIT – 2,40,000) = (5,40,000)/(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

=> 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:

EPS_PLAN
1 = [0.6 EBIT – 1,80,000] ÷ 5,40,000

[0.6 × 16,50,000 - 1,80,000] ÷ 5,40,000 = Rs. 1.5

EPS_PLAN
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

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 (.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.

=> 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.

[(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

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 ([EBIT × (1-t)-PD1] )/N1 = ([(EBIT – I) × (1- t) – PD2)/(N2 ) => ([(EBIT × (1-0.3)- 80,000] )/(12,000) = ([(EBIT – 96,000) × (1- 0.3) – 40,000)/(8,000) 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

=> 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