Omega Ltd. has total funds of Rs. 50 lakh, made up of equity of Rs. 35 lakh and debt of Rs. 15 lakh at 10% p.a. Its EBIT is Rs. 4.5 lakh. Which of the following is correct?
Answer & explanation
Correct answer: option 1
The correct answer is Option (1) → Its RoI is 9%, so it faces unfavourable financial leverage.
Given:
Total funds = Rs. 50 lakh (equity Rs. 35 lakh)
Debt = Rs. 15 lakh at 10% p.a.
EBIT = Rs. 4.5 lakh
Formula: RoI = EBIT / Total investment × 100
RoI = 4.5 / 50 × 100 = 9%
9% is below the 10% cost of debt.
Result: RoI 9%; debt costs more than it earns, so this is unfavourable financial leverage.
Option (1) Its RoI is 9%, so it faces unfavourable financial leverage. — Correct. Both the RoI and the leverage are right.
Option (2) Its RoI is 12.86%, so it enjoys favourable financial leverage. — Incorrect. 12.86% comes from 4.5 / 35, that is, EBIT divided by equity alone. RoI uses the total funds of Rs. 50 lakh.
Option (3) Its RoI is 6%, so it faces unfavourable financial leverage. — Incorrect. 6% comes from (4.5 − 1.5) / 50, which takes off the interest first. RoI uses EBIT, the earning before interest.
Option (4) Its RoI is 9%, so it enjoys favourable financial leverage. — Incorrect. The RoI is right, but leverage is favourable only when RoI is higher than the cost of debt. Here it is lower.
NCERT (2026-27 Edition): “Example II In this example, the EPS of the company is falling with increased use of debt. It is because the Company’s rate of return on investment (RoI) is less than the cost of debt. … In such cases, the use of debt reduces the EPS. This is a situation of unfavourable financial leverage. Trading on Equity is clearly unadvisable in such a situation.” |