A company has a total investment of Rs. 40 lakh, made up of equity of Rs. 32 lakh and debt of Rs. 8 lakh. Its EBIT is Rs. 3.6 lakh. It can raise more debt at 8% p.a.
Statement I: The return on investment (RoI) of the company is 11.25 per cent.
Statement II: If its EBIT falls to Rs. 2.8 lakh on the same total investment, raising more debt at 8% p.a. would reduce 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 4
The correct answer is Option (4) → Statement I is incorrect but Statement II is correct.
Given:
Total investment = Rs. 40 lakh (equity Rs. 32 lakh + debt Rs. 8 lakh)
EBIT = Rs. 3.6 lakh; cost of new debt = 8% p.a.
RoI = EBIT ÷ Total investment × 100
Statement I: The return on investment (RoI) of the company is 11.25 per cent. — Incorrect.
RoI = 3.6 ÷ 40 × 100 = 9 per cent
The figure 11.25 per cent comes from 3.6 ÷ 32, which uses equity alone.
Statement II: If its EBIT falls to Rs. 2.8 lakh on the same total investment, raising more debt at 8% p.a. would reduce its earnings per share (EPS). — Correct.
New RoI = 2.8 ÷ 40 × 100 = 7 per cent
This is below the 8 per cent cost of debt.
So each rupee of new debt earns less than the interest paid on it, and more debt reduces the EPS. This is unfavourable financial leverage.
NCERT (2026-27 Edition): Example II
|
