Company P earns an EBIT of Rs. 9 lakh on a total investment of Rs. 60 lakh. Company Q earns an EBIT of Rs. 4.2 lakh on a total investment of Rs. 60 lakh. Both companies can borrow at 11% p.a.
Statement I: For Company P, a higher use of debt at 11% will increase its earnings per share (EPS).
Statement II: For Company Q, a higher use of debt at 11% will increase its earnings per share (EPS).
In the light of the above statements, choose the correct answer from the options given below:
Answer & explanation
Correct answer: option 3
The correct answer is Option (3) → Statement I is correct but Statement II is incorrect.
Given:
Company P: EBIT = Rs. 9 lakh; Total investment = Rs. 60 lakh
Company Q: EBIT = Rs. 4.2 lakh; Total investment = Rs. 60 lakh
Cost of debt = 11% p.a.
RoI = EBIT ÷ Total investment × 100
Company P: RoI = 9 ÷ 60 × 100 = 15%
Company Q: RoI = 4.2 ÷ 60 × 100 = 7%
More debt raises the EPS only when the RoI is higher than the cost of debt.
Statement I: For Company P, a higher use of debt at 11% will increase its earnings per share (EPS). — Correct.
RoI of 15% is above the 11% cost of debt.
So more debt raises the EPS.
Statement II: For Company Q, a higher use of debt at 11% will increase its earnings per share (EPS). — Incorrect.
RoI of 7% is below the 11% cost of debt.
So more debt reduces the EPS.
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.” |