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CS Professional · Strategic Management and Corporate Finance · Business Policy and Formulation of Functional Strategy

Sundaram Auto Ltd. expects to earn an operating profit (EBIT) of ₹20 lakh. It has two financing plans for a ₹100 lakh requirement. Plan A: all equity of 10 lakh shares at ₹10 each. Plan B: 5 lakh equity shares at ₹10 each and ₹50 lakh debt at 10% interest. Ignore tax. What is the EPS under Plan B, and what does comparing it to Plan A show?

EPS under Plan B is ₹3 against ₹2 under Plan A. Interest of ₹5 lakh leaves ₹15 lakh for 5 lakh shares. Because the 20% return on capital exceeds the 10% cost of debt, financial leverage raises EPS.

  1. A₹3.00 under Plan B, higher than ₹2.00 under Plan A, showing favourable financial leverageCorrect
  2. B₹2.00 under Plan B, same as Plan A, showing no leverage effect
  3. C₹4.00 under Plan B, higher than ₹2.00 under Plan A, showing favourable financial leverage
  4. D₹3.00 under Plan B, lower than Plan A, showing unfavourable leverage

Explanation

Plan A EPS = 20 lakh / 10 lakh shares = ₹2. Plan B interest = 10% of 50 lakh = ₹5 lakh; profit = 15 lakh; EPS = 15/5 = ₹3. Since return on investment (20%) exceeds the 10% cost of debt, leverage is favourable. Option with ₹4 ignores interest... it divides 20 lakh by 5 lakh shares.

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