Question

‘Ratan Ltd.’ and ‘Lara Ltd.’ are two companies with each having a capital employed of ₹ 20,00,000. ‘Ratan Ltd.’ had raised funds by issuing shares whereas ‘Lara Ltd.’s’ capital has 60% equity (in shares of ₹ 100 each) and 40% debt (comprising of 8% debentures). Both the companies have a Return on Investment of 10% and the tax rate is 40%. State with reason which company will be able to give a better return to the shareholders. Show your calculations clearly.

Hint:

Remember: Whenever ROI > Rate of Interest, injecting debt into the capital structure will always increase the EPS for shareholders.

Answer 1

Correct Answer: 8

Step 1: Understand the concept being tested.
This question tests the concept of Trading on Equity (also called Financial Leverage). The idea is: if a company borrows money at a fixed interest rate that is lower than its Return on Investment (ROI), the extra earnings benefit only the equity shareholders, increasing their earnings per share (EPS).
Step 2: List the common data for both companies.
Total Capital Employed = Rs. 20,00,000. ROI = 10%, so Earnings Before Interest and Tax (EBIT) = 10% of Rs. 20,00,000 = Rs. 2,00,000. Tax Rate = 40%. Face value of each share = Rs. 100.
Step 3: Calculate EPS for Ratan Ltd. (100% Equity).
Equity Capital = Rs. 20,00,000. Number of equity shares = Rs. 20,00,000 divided by Rs. 100 = 20,000 shares. Interest on debt = Rs. 0 (no debt). Earnings Before Tax (EBT) = Rs. 2,00,000 minus Rs. 0 = Rs. 2,00,000. Tax at 40% = Rs. 80,000. Earnings After Tax (EAT) = Rs. 2,00,000 minus Rs. 80,000 = Rs. 1,20,000. $\text{EPS (Ratan Ltd.)} = \dfrac{1{,}20{,}000}{20{,}000} = \text{Rs. } 6.00$
Step 4: Calculate EPS for Lara Ltd. (60% Equity, 40% Debt).
Equity = 60% of Rs. 20,00,000 = Rs. 12,00,000. Number of equity shares = Rs. 12,00,000 divided by Rs. 100 = 12,000 shares. Debt = 40% of Rs. 20,00,000 = Rs. 8,00,000 at 8% interest. Interest = 8% of Rs. 8,00,000 = Rs. 64,000. EBT = Rs. 2,00,000 minus Rs. 64,000 = Rs. 1,36,000. Tax at 40% = Rs. 54,400. EAT = Rs. 1,36,000 minus Rs. 54,400 = Rs. 81,600. $\text{EPS (Lara Ltd.)} = \dfrac{81{,}600}{12{,}000} = \text{Rs. } 6.80$
Step 5: Compare and decide which company gives better returns.
Ratan Ltd. EPS = Rs. 6.00; Lara Ltd. EPS = Rs. 6.80. Lara Ltd. gives a higher return per share to its shareholders.
Step 6: State the reason using the financial leverage logic.
Lara Ltd. benefits from Trading on Equity because its ROI (10%) is greater than its Cost of Debt (8%). The extra profit earned from borrowed funds (after paying interest) goes entirely to the equity shareholders, boosting their EPS above that of Ratan Ltd.
\[ \boxed{ \text{Lara Ltd. gives better return; EPS = Rs. 6.80 vs Ratan Ltd. EPS = Rs. 6.00 (Trading on Equity)} } \]