2.

EBIT – EPS ANALYSIS

Q1 (SM 2014 4.34)

Alpha Ltd. is setting up a project with a capital outlay of ` 60,00,000. It has two alternatives in
financing the project cost.
Alternative (a):100% equity finance Alternative (b): Debt-equity ratio 2:1
The rate of interest payable Of the debts is 18% p.a. The corporate tax rate is 40%. Calculate
the indifference point between the two alternative methods of financing.
Ans. 10,80,000

Q2 (PE-II M03 3 Marks) (PM 2016 4.40)

Calculate the level of earnings before interest and tax (EBIT) at which the EPS indifference point
between the following financing alternatives will occur.
(i) Equity share capital of `6,00,000 and 12% debentures of `4,00,000
Or
(ii) Equity share capital of `4,00,000, 14% preference share capital of `2,00,000 and 12%
debentures of `4,00,000.
Assume the corporate tax rate is 35% and par value of equity share is `10 in each case.
Ans. `1,77,231

Q3 (CA PE-II M08 4 Marks) (PM 2016 4.41)

A new project is under consideration in Zip Ltd., which requires a capital investment of ` 4.50 crore.
Interest on term loan is 12% and Corporate Tax rate is 50%. If the Debt Equity ratio insisted by the
financing agencies is 2 : 1, calculate the point of indifference for the project.
Ans. ` 54 lakhs

Q4 (CA IPCC N13 5 Marks) (PM 2016 4.43)

X Ltd. is considering the following two alternative financing plans:
Plan - I (`) Plan – II (`)
Equity shares of ` 10 each 4,00,000 4,00,000
12% Debentures 2,00,000 -
Preference Shares of ` 100 each - 2,00,000
6,00,000 6,00,000
The indifference point between the plans is ` 2,40,000. Corporate tax rate is 30%. Calculate

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 2.2 Financial Management

the rate of dividend on preference shares.

Ans. 8.4%

Q5 (CA IPCC N14 5 Marks)

Alpha Limited requires funds amounting to ` 80 lakhs for its new project. To raise the funds, the
company has following two alternatives:
(i) to issue Equity Shares (at par) amounting to ` 60 lakhs and borrow the balance amount at the
interest of 12% p.a.; or
(ii) to issue Equity Shares (at par) and 12% Debentures in equal proportion.
The Income-tax rate is 30%.
Find out the point of indifference between the available two modes of financing and state which
option will be beneficial in different situations.
Ans. 9,60,000

Q6 (SM 2014 4.32)

Best of Luck Ltd., a profit making company, has a paid-up capital of `100 lakhs consisting of 10 lakhs
ordinary shares of `10 each. Currently, it is earning an annual pre-tax profit of `60 lakhs. The
company's shares are listed and are quoted in the range of `50 to `80. The management wants to
diversify production and has approved a project which will cost `50 lakhs and which is expected to
yield a pre-tax income of `40 lakhs per annum. To raise this additional capital, the following
options are under consideration of the management:
(a) To issue equity capital for the entire additional amount. It is expected that the new shares
(face value of `10) can be sold at a premium of `15.
(b) To issue 16% non-convertible debentures of `100 each for the entire amount.
(c) To issue equity capital for `25 lakhs (face value of `10) and 16% non-convertible debentures
for the balance amount. In this case, the company can issue shares at a premium of `40 each.
You are required to advise the management as to how the additional capital can be raised, keeping
in mind that the management wants to maximize the earnings per share to maintain its goodwill.
The company is paying income tax at 50%.
Ans. `4.17; `4.60; `4.57

Q7 (CA PE-II M08 8 Marks) (PM 2016 4.66)

Delta Ltd. currently has an equity share capital of ` 10,00,000 consisting of 1,00,000 Equity share of
` 10 each. The company is going through a major expansion plan requiring to raise funds to the

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EBIT-EPS Analysis
2.3

tune of ` 6,00,000. To finance the expansion the management has following plans:
Plan-I : Issue 60,000 Equity shares of ` 10 each.
Plan-II : Issue 40,000 Equity shares of ` 10 each and the balance through longterm borrowing at
12% interest p.a.
Plan-III : Issue 30,000 Equity shares of `10 each and 3,000 `100, 9% Debentures.
Plan-IV : Issue 30,000 Equity shares of ` 10 each and the balance through 6% preference shares.
The EBIT of the company is expected to be ` 4,00,000 p.a. assume corporate tax rate of 40%.
Required:
(i) Calculate EPS in each of the above plans.
(ii) Ascertain the degree of financial leverage in each plan.
Ans. (i) 1.50 1.61 1.72 1.71 (ii) 1.00, 1.06, 1.07, 1.00

Q8 (SM 2014 4.33) (CA Final N99 7 Marks) (IPCC N16 8 Marks, only (i))
The Modern Chemicals Ltd. requires ` 25,00,000 for a new plant. This plant is expected to yield
earnings before interest and taxes of ` 5,00,000. While deciding about the financial plan, the
company considers the objective of maximising earnings per share. It has three alternatives to
finance the project- by raising debt of ` 2,50,000 or ` 10,00,000 or ` 15,00,000 and the balance, in
each case, by issuing equity shares. The company’s share is currently selling at ` 150, but is
expected to decline to ` 125 in case the funds are borrowed in excess of ` 10,00,000. The funds can
be borrowed at the rate of 10% upto ` 2,50,000, at 15% over ` 2,50,000 and upto ` 10,00,000 and
at 20% over ` 10,00,000. The tax rate applicable to the company is 50%.
Required:
(i) Which form of financing should the company choose?
(ii) Find the indifference level of EBIT between various plans.
Ans. (i) 15.83, 18.13, 16.41 (ii) 362500, 637500, 480357

Q9 (CS J09 12 MARKS) (SM 2014 4.35)

Gamma Ltd. is considering three financing plans. The key information is as follows:
(a) Total investment to be raised `2,00,000
(b) Plans of Financing Proportion:
Plans Equity Debt Preference Shares
A 100% - -
B 50% 50% -
C 50% - 50%
(c) Cost of debt 8%; Cost of preference shares 8%

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 2.4 Financial Management

(d) Tax rate 50%.

(e) Equity shares of the face value of `10 each will be issued at a premium of `10 per share.
(f) Expected PBIT is `80,000.
You are required to determine for each plan: -
(1) Earnings per share (EPS)
(2) The financial break-even point.
(3) Compute the PBIT range among the plans for indifference and Indicate if any of the plans
dominate.
Ans. (1) 4, 7.20, 6.40 (2) 0, 8000, 16000 (3) 16000, 32000

Q10 (CA IPCC M11 12 Marks) (PM 2016 4.49)

The management of Z Company Ltd. wants to raise its funds from market to meet out the financial
demands of its long-term projects. The company has various combination of proposals to raise its
funds. You are given the following proposals of the company:
(i) Proposals % of Equity % of Debts % of Preference shares
P 100 - -
Q 50 50 -
R 50 - 50
(ii) Cost of debt – 10%; Cost of preference shares – 10%
(iii) Tax rate – 50%
(iv) Equity shares of the face value of ` 10 each will be issued at a premium of ` 10 per share.
(v) Total investment to be raised ` 40,00,000.
(vi) Expected earnings before interest and tax ` 18,00,000.
From the above proposals the management wants to take advice from you for appropriate plan
after computing the following:
· Earnings per share · Financial break-even-point
Compute the EBIT range among the plans for indifference. Also indicate if any of the plans
dominate.
Ans. (i)4.5, 8, 7 (ii) 0, 200000, 400000 (iii)400000, 800000

Q11 (CA PE-II N02 6 Marks) (PM 2016 4.46)

A Company earns a profit of `3,00,000 per annum after meeting its Interest liability of `1,20,000 on
12% debentures. The Tax rate is 50%. The number of Equity Shares of `10 each are 80,000 and the
retained earnings amount to `12,00,000. The company proposes to take up an expansion scheme
for which a sum of `4,00,000 is required. It is anticipated that after expansion, the company will be
able to achieve the same return on investment as at present. The funds required for expansion can
be raised either through debt at the rate of 12% or by issuing Equity Shares at par.

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EBIT-EPS Analysis
2.5

Required:
(i) Compute the Earnings Per Share (EPS), if:
− the additional funds were raised as debt
− the additional funds were raised by issue of equity shares.
(ii) Advise the company as to which source of finance is preferable.
Ans (i) 1.925, 1.48 (ii) Debt scheme is better.

Q12 (CA PE-II N05 10 Marks) (PM 2016 4.49)

A Company needs ` 31,25,000 for the construction of new plant. The following three plans are
feasible:
I The Company may issue 3,12,500 equity shares at ` 10 per share.
II The Company may issue 1,56,250 ordinary equity shares at ` 10 per share and 15,625
debentures of Rs,. 100 denomination bearing a 8% rate of interest.
III The Company may issue 1,56,250 equity shares at ` 10 per share and 15,625 preference shares
at ` 100 per share bearing a 8% rate of dividend.
Required:
(i) if the Company's earnings before interest and taxes are ` 62,500, ` 1,25,000, ` 2,50,000, `
3,75,000 and ` 6,25,000, what are the earnings per share under each of three financial
plans ? Assume a Corporate Income tax rate of 40%.
(ii) Which alternative would you recommend and why?
(iii) Determine the EBIT-EPS indifference points by formulae between Financing Plan I and Plan II
and Plan I and Plan III.
Ans. (i) 1.20, 1.92, 1.60 (iii) 250000; 416667

Q13 (SM 2014 4.39)

Yoyo Limited presently has ` 36,00,000 in debt outstanding bearing an interest rate of 10 per cent.
It wishes to finance a ` 40,00,000 expansion programme and is considering three alternatives:
additional debt at 12 per cent interest, preference shares with an 11 per cent dividend, and the sale
of equity shares at ` 16 per share. The company presently has 8,00,000 shares outstanding and is in
a 40 per cent tax bracket.
(a) If earnings before interest and taxes are presently ` 15,00,000, what would be earnings per
share for the three alternatives, assuming no immediate increase in profitability?
(b) What is the indifference point mathematically between debt and common?
(c) Which alternative do you prefer? How much would EBIT need to increase before the next

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 2.6 Financial Management

alternative would be best?

Ans. (a).495 .305 .651 (b) 2376 (c) Common stock is clearly preferable, `876

Q14 (RTP PE-II M05) (SM PCC PG(4.66)

AB limited provides you with following figures:
`
Profit 3,00,000
Less: Interest on Debentures @ 12% 60,000
2,40,000
Income-tax @ 50% 1,20,000
1,20,000
Number of Equity Shares (` 10 each) 40,000
E.P.S. (Earning per share) (`) 3
Ruling price in market (`) 30
PE ratio (Market Price/EPS) 10
The company has undistributed reserves of `6,00,000. The company needs `2,00,000 for
expansion. This amount will earn at the same rate as funds already employed. You are informed
that a Debt Equity Ratio Debt/(Debt +Equity) higher than 35% will push the P/E ratio down to 8 and
raise the interest rate on additional amount borrowed to 14%. You are required to ascertain the
probable price of the share:
(i) If the additional funds are raised as debt
(ii) If the amount is raised by issuing equity shares.
Ans. 25.20, 30

Q15 (RTP PCC N11)

Alpha Limited has the following capital structure:
Equity Share Capital (` 10 each) ` 150 lakhs
10% Debentures ` 100 lakhs
Retained Earnings ` 50 lakhs
Other Information:
Market Price per Equity Share ` 49
Price-Earnings Ratio 7
Income Tax Rate 30%
Alpha Limited is considering an expansion plan and needs ` 100 lakhs. If expansion programme is
undertaken, company feels that there will be 25% increase in present earnings before interest and
tax. The company has the following alternatives available for raising funds required for

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EBIT-EPS Analysis
2.7

expansion:
I. Issue equity shares at ` 50 each.
II. Issue 12 % debentures for ` 50 lakhs and for the balance, equity shares at ` 50 each.
III. Issue 9 % preference shares for ` 60 lakhs and for the balance, equity shares at ` 50 each.
You are required to advise Alpha Limited regarding the best alternative assuming price-earnings
ratio 7.50, 7.00 and 7.25 respectively for these alternatives.
Ans. 58.65, 56.35, 58.50

Q16 (PM 2014 4.84 Ex.)

X Ltd. a widely held company is considering a major expansion of its production facilities and the
following alternatives are available:
Alternatives (` in lakhs)
A B C
Share Capital 50 20 10
14% Debentures - 20 15
Loan from a Financial Institution @ 18% p.a. Rate of Interest. - 10 25
Expected rate of return before tax is 25%. The rate of dividend of the company is not less than 20%.
The company at present has low debt. Corporate taxation 50%
Which of the alternatives you would choose?
Ans. 1.25, 1.975, 2.95

Q17 (RTP PE-II M08)

Sai Company is attempting to establish a current assets policy. Fixed assets are `6,00,000 and the
firm plans to maintain a 50 per cent debt-to-assets ratio. The interest rate is 10 per cent on all debt.
Three alternative current asset policies are under consideration: 40, 50, and 60% of projected sales.
The company expects to earn 15 per cent before interest and taxes on sales of `30 lakhs. The
Company’s effective tax rate is 40 per cent. What is the expected return on equity under each
alternative?
Ans. 24.0% 19.7% 16.5%

Q18 (PM 2016 4.61)

The net Sales of Apex Co. are `15 crores. EBIT of the company as a % of Net Sales is 12%. The
capital employed comprises `5 crores of equity, `1 crore of cumulative redeemable preference
share bearing 13% rate of dividend and debt capital of `3 crores at an annual interest rate of 15%.

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 2.8 Financial Management

Corporate income tax rate is 40%.

Required:
(i) Calculate the Return on Equity (ROE) for the company.
(ii) Calculate the Operating Leverage of the company given that its combined leverage is 3.
Ans. 13.6%, 1.8917

Q19 (RTP PE-II N08)

ABC Ltd. is in process of raising `500000 as additional capital. For this purpose two mutually
exclusive alternative financial plans, have been identified. The current level of EBIT is `1700000,
which is likely to remain unchanged. The relevant information is as follows:
Present Capital Structure: 300000 Equity Shares of `10 each, and 10% Bonds of `2000000
Tax Rate 50%
Current EPS `2.50
Current market Price `25 per share
Financial Plan I Equity shares @ `25 per share
Financial Plan II 12% Debentures of `500000
What is the indifference level of EBIT? Identify the financial break-even levels. Which alternative
financial plan is better?
Ans. 1160000; `2,00,000; `2,60,000; 2.34, 2.40, Plan 2

Q20
TVS Motors currently has 100000 shares of common stock outstanding with a market price of `50
per share. It also has `2 million in 7% bonds (currently selling at par). The company is considering a
`4 million expansion program that it can finance with either all common stock at `50 per share or
all bonds at 9%. The company estimates that if the expansion program is undertaken, it can attain
in the near future, `1 million in EBIT. The company’s tax rate is 40%.
Required:
(1) Calculate the EPS for each plan.
(2) What is the indifference point between the alternatives?
(3) If the expected EBIT for the near future is greater than your answer in (3) what form of
financing would you recommend?
Ans. (1) 2.86, 3 (2) 950000 (3) b

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