A company needs total funds of Rs. 80 lakh. It expects an EBIT of Rs. 6 lakh. Debt can be raised at 10% p.a., the rest by equity shares of Rs. 10 each, and the tax rate is 25%. It is considering three plans:
| Plan X | No debt |
| Plan Y | Debt of Rs. 40 lakh |
| Plan Z | Debt of Rs. 20 lakh |
Which plan gives the highest EPS, and what is that EPS?
Answer & explanation
Correct answer: option 4
The correct answer is Option (4) → Plan X, Rs. 0.56
Given:
Total funds = Rs. 80 lakh
EBIT = Rs. 6 lakh
Debt at 10% p.a.
Equity shares of Rs. 10 each
Tax rate = 25%
Formula: EPS = (EBIT − Interest) × (1 − tax rate) / Number of equity shares
Plan X (no interest): EAT = 6 × 0.75 = Rs. 4.5 lakh
Plan X: EPS = 4.5 / 8 lakh shares = Rs. 0.56
Plan Y (interest 4): EAT = (6 − 4) × 0.75 = Rs. 1.5 lakh
Plan Y: EPS = 1.5 / 4 lakh shares = Rs. 0.38
Plan Z (interest 2): EAT = (6 − 2) × 0.75 = Rs. 3 lakh
Plan Z: EPS = 3 / 6 lakh shares = Rs. 0.50
Result: Plan X gives the highest EPS, Rs. 0.56.
The RoI is 6 / 80 = 7.5%, below the 10% interest, so every rupee of debt lowers EPS.
Option (1) Plan Z, Rs. 0.50 — Incorrect. Rs. 0.50 is Plan Z's EPS, but it is lower than Plan X's.
Option (2) Plan X, Rs. 0.75 — Incorrect. This is 6 / 8, with the tax left out.
Option (3) Plan Y, Rs. 1.13 — Incorrect. This is 4.5 / 4, which uses Plan Y's shares but leaves out its interest of Rs. 4 lakh.
Option (4) Plan X, Rs. 0.56 — Correct. As worked out above.
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.” |