Four firms can each borrow at 11% p.a. Which firm will see its earnings per share (EPS) rise if it uses more debt?
Answer & explanation
Correct answer: option 2
The correct answer is Option (2) → Firm Q: EBIT Rs. 9 lakh on a total investment of Rs. 75 lakh
Given:
Cost of debt = 11% p.a. for every firm
RoI = EBIT ÷ Total investment × 100
Firm Q: RoI = 9 ÷ 75 × 100 = 12%
Only Firm Q earns more on its funds (12%) than its debt costs (11%).
The extra 1% earned on borrowed money goes to the equity shareholders, so its EPS rises. This is favourable financial leverage.
Option (1) Firm P: EBIT Rs. 6 lakh on a total investment of Rs. 60 lakh — Incorrect. RoI = 6 ÷ 60 × 100 = 10%. This is below the 11% cost of debt, so more debt lowers the EPS.
Option (3) Firm R: EBIT Rs. 5.5 lakh on a total investment of Rs. 50 lakh — Incorrect. RoI = 5.5 ÷ 50 × 100 = 11%. It only equals the cost of debt, so there is no gap to raise the EPS.
Option (4) Firm S: EBIT Rs. 8.4 lakh on a total investment of Rs. 80 lakh — Incorrect. RoI = 8.4 ÷ 80 × 100 = 10.5%. This is just below 11%, so more debt lowers 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.” |