Answer the questions on the basis of the information given below.
Company X
TOTAL FUND USED = 30 LAKHS
| Face value of share |
₹10/- |
| Interest rate on Debt | 10% |
| Tax rate | 30% |
| EBIT | 4 Lakhs |
| Situation I (Debt) | Nil |
| Situation II (Debt) | 10 Lakhs |
Choose the correct answer from the options given below:
Identify the situation in which company X can avail the benefit of trading on equity.
Answer & explanation
Correct answer: option 2
The correct answer is option 2- Situation II.
** SITUATION I-
EBIT = 4,00,000
less: Interest = NIL
EBT 4,00,000 (Earnings before taxes)
less: Tax 1,20,000
EAT 2,80,000
Earning per share = EAT/ no of shares
No of shares = 30 lakhs/10
= 300000
EPS = 280000/300000
= 0.93
** SITUATION II-
In this situation total fund is 30 lakhs in which 10 lakhs is debt so share capital is 20 lakhs.
EBIT = 4,00,000
less: Interest = 100000
EBT = 3,00,000 (Earnings before taxes)
less: Tax = 90,000
EAT 2,10,000
Earning per share = EAT/ no of shares
No of shares = 20 lakhs/10
= 200000
EPS = 210000/200000
= 1.05
THUS, EPS IS MORE IN SITUATION II WITH USE OF DEBT. SO, COMPANY CAN AVAIL BENEFIT OF TRADING ON EQUITY WITH SITUATION II.