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CMA Intermediate · Financial Management and Business Data Analytics · Leverage Analyses and EBIT - EPS Analysis

Kaveri Auto expects EBIT of ₹6,00,000. The indifference EBIT between equity and debt financing plans is ₹4,50,000. Ignoring tax and assuming debt cost is below the return on assets, which decision follows?

Debt financing should be chosen. Since expected EBIT of ₹6,00,000 is above the ₹4,50,000 indifference point, the leveraged plan gives higher EPS, as fewer shares share the profit after fixed interest.

  1. AChoose equity, because expected EBIT exceeds the indifference point and gives higher EPS
  2. BChoose debt, because expected EBIT exceeds the indifference point and gives higher EPSCorrect
  3. CChoose debt, because expected EBIT is below the indifference point
  4. DEither plan, because EPS is identical above the indifference point

Explanation

Above the indifference EBIT, the plan with more fixed financing cost (debt) yields higher EPS because the fixed interest is spread over a larger profit and fewer shares. Expected EBIT of ₹6,00,000 exceeds ₹4,50,000, so debt is preferred. Choosing equity would be right only below the indifference point.

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