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 (ROI) 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.

• A. Ratan Ltd. will give a higher EPS
• B. Lara Ltd. will give a higher EPS
• C. Both companies will give the same EPS
• D. Cannot be determined from the given data

Hint:

Before doing long calculations, check this quick condition: If \(\text{ROI} \gt \text{Interest Rate}\), the company with more debt will always yield a higher EPS. If \(\text{ROI} \lt \text{Interest Rate}\), debt acts as a drag, and the purely equity-based company will perform better.

Answer 1

The Correct Option is B

Step 1: What decides the better return here.
To see which company rewards its shareholders better, we compare Earnings Per Share (EPS), and the concept behind the comparison is trading on equity, using fixed cost debt to boost equity returns when the return earned on capital is higher than the interest paid on that debt.
Step 2: Working out profit after interest and tax.
Capital employed is Rupees 20,00,000 for both firms and ROI is 10 percent, so EBIT for both = 2,00,000. Ratan Ltd, being all equity financed, has no interest to pay, so its EBT stays at 2,00,000; tax at 40 percent = 80,000, leaving EAT of 1,20,000. Lara Ltd has 8,00,000 as 8 percent debentures, so interest = 64,000; EBT becomes 1,36,000, tax at 40 percent = 54,400, leaving EAT of 81,600.
Step 3: Converting profit into EPS.
Ratan Ltd has 20,000 equity shares of Rupees 100 each (since its full 20,00,000 came from shares), giving EPS = 1,20,000 divided by 20,000 = Rupees 6. Lara Ltd has only 12,000 equity shares of Rupees 100 each (60 percent of 20,00,000), giving EPS = 81,600 divided by 12,000 = Rupees 6.8.
Final answer: Option 2, Lara Ltd. will give a higher EPS, because its ROI of 10 percent exceeds the 8 percent cost of debt, so trading on equity works in its favour.