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CS Executive · Corporate Accounting and Financial Management · Operational Approach to Financial Decision

When actual expected EBIT is well above the indifference point between an equity plan and a debt plan, and the return on investment exceeds the cost of debt, the financing plan that maximises EPS is generally:

The debt plan maximises EPS, because above the indifference point the firm earns more on borrowed funds than the interest it pays, so financial leverage is favourable and EPS rises faster than under the equity plan.

  1. AThe debt plan, because of favourable financial leverageCorrect
  2. BThe equity plan, because of fewer shares being issued
  3. CEither plan, as EPS is then identical
  4. DThe plan with the higher number of shares outstanding

Explanation

Above the indifference point the plan with more financial leverage gives higher EPS, since the earning rate on funds exceeds the cost of debt. Equal EPS occurs only at the indifference point itself.

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