Question

Krish limited is in the business of manufacturing and exporting carpets and other home decor products. It has a share capital of ₹ 70 lacs at the face value of ₹ 100 each. Company is considering a major expansion of its production facilities and wants to raise ₹ 50 lacs. The finance manager of the company Mr. Prabhakar has recommended that the company can raise funds of the same amount by issuing 7% debentures. Given that earning per share of the company after expansion is ₹ 35 and tax rate is 30%, did Mr. Prabhakar give a justified recommendation?

Show the working.

Answer 1

Earnings per share = ₹ 35

EPS = `("Earning after tax") / ("No. of equity shares")`

35 = `("Earning after tax") / (70,000)`

Earning after tax = ₹ 24,50,000

Interest = `50,00,000 xx7/100` = ₹ 3,50,0000

Let the Earning before tax (EBT) = x

EBT - Tax = EAT

X - 0.30 x = 24,50,000

0.70 x = 24,50,000

x = `(24,50,000)/0.70`

x = 35,00,000

Earning before tax = ₹ 35,00,000

EBIT = Earning before tax + Interest

= 35,00,000 + 3,50,000

= ₹ 38,50,000

ROI = `("EBIT")/("total Investment") × 100`

= `(38,50,000) / (1,20,00,000)× 100`

= 32.08%

As ROI (32.08%) > Rate of interest (7%). The company can choose to use trading on equity to increase its EPS. The finance manager was justified in making this recommendation.