Question

Sahil Industries needs to raise funds of Rs.30,00,000. Its expected earnings before interest and taxes (EBIT) are Rs. 2,00,000. The company wishes to use more of debt content as compared to equity to raise earning per share (EPS) of equity shareholders. The debt is available at interest of 10%. As finance Manager, advise whether the company should prefer more of debt or more of equity to have higher EPS. Give reasons to support your answer.

Answer 1

Sahil Industries should use less of debt (preferably no debt) to have higher EPS because current return on investment (ROI) is less than cost of debt. The prevailing ROI is only 6.66% (=2,00,000/30,00,000 * 100) against the interest rate of 10%. When ROI is less than interest rate on debt, then EPS falls with rise in use of debt. So, the company should prefer more of equity to have higher EPS.