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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.
Solution
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.
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