Sigma Ltd. has a total investment of Rs. 50 lakh, made up of equity of Rs. 40 lakh and debt of Rs. 10 lakh at 11% p.a. Its EBIT is Rs. 6 lakh and the tax rate is 30%. It plans to raise more funds by issuing debentures at 11% p.a. Should it issue the debentures to increase its earnings per share (EPS)?
Answer & explanation
Correct answer: option 3
The correct answer is Option (3) → Yes, because its RoI of 12% is higher than the 11% cost of debt.
Given:
Total investment = Rs. 50 lakh (equity Rs. 40 lakh + debt Rs. 10 lakh)
EBIT = Rs. 6 lakh; Tax rate = 30%
Cost of debt = 11% p.a.
RoI = EBIT ÷ Total investment × 100
RoI = 6 ÷ 50 × 100 = 12%
12% is higher than the 11% cost of debt, so more debt will raise the EPS.
This is favourable financial leverage, and the company can use trading on equity.
Option (1) Yes, because its RoI of 15% is higher than the 11% cost of debt. — Incorrect. The RoI is wrong: 6 ÷ 40 = 15% uses equity alone. RoI is worked on the total investment.
Option (2) No, because its RoI of 9.8% is lower than the 11% cost of debt. — Incorrect. This deducts interest first: (6 − 1.1) ÷ 50 = 9.8%. RoI uses EBIT, before interest.
Option (4) No, because its RoI of 8.4% is lower than the 11% cost of debt. — Incorrect. This deducts tax first: 4.2 ÷ 50 = 8.4%. RoI uses EBIT, before tax.
NCERT (2026-27 Edition): “4. Return on Investment (RoI): If the RoI of the company is higher, it can choose to use trading on equity to increase its EPS, i.e., its ability to use debt is greater. We have already observed in Example I that a firm can use more debt to increase its EPS. However, in Example II, use of higher debt is reducing the EPS. It is because the firm is earning an RoI of only 6.67% which lower than its cost of debt. In example I the RoI is 13.33%, and trading on equity is profitable. It shows that, RoI is an important determinant of the company’s ability to use Trading on equity and thus the capital structure.” |