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CMA Intermediate · Financial Management and Business Data Analytics · Capital Structure and Capital Stacking

Under EBIT-EPS analysis, a firm's expected EBIT is Rs 5,00,000, above the indifference EBIT of Rs 3,00,000 between an all-equity plan and a debt plan. Assuming the debt cost is lower than the firm's return on assets at that EBIT, which conclusion follows?

The debt plan gives higher EPS. Beyond the indifference EBIT, earnings from the borrowed funds exceed interest cost and are spread over fewer shares, so the debt EPS line rises above the equity line. Only below that EBIT does equity financing deliver higher EPS.

  1. AThe equity plan gives higher EPS
  2. BThe debt plan gives higher EPSCorrect
  3. CBoth plans give identical EPS
  4. DThe debt plan gives lower EPS but lower risk

Explanation

Above the indifference point, the debt plan's EPS line lies above the equity plan's line because the debt plan has fewer shares and EBIT more than covers the extra interest. The equity plan is better only below the indifference point. Equal EPS occurs only at the point itself.

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