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CS Executive · Corporate Accounting and Financial Management · Capital Structure

A firm chooses between equity financing and debt financing. Its expected EBIT is Rs 3,00,000, above the indifference EBIT of Rs 2,00,000. Ignoring risk, which conclusion follows from EBIT-EPS analysis?

Debt financing gives higher EPS. When expected EBIT is above the indifference point, financial leverage works favourably because earnings on borrowed funds exceed the interest cost, so the debt plan yields more EPS than the all-equity plan.

  1. AEquity financing gives higher EPS because EBIT exceeds the indifference point
  2. BBoth plans give equal EPS at the expected EBIT
  3. CDebt financing gives higher EPS because EBIT exceeds the indifference pointCorrect
  4. DEPS cannot be compared without knowing the dividend payout

Explanation

Above the indifference point the plan with fixed financial charges magnifies EPS through leverage, provided the return on assets exceeds the interest cost. Option A reverses the rule, which applies only below the point.

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