Question

A company's earnings before interest and tax is Rs. 7 lakh. It pays 10% interest on its debt. Total investment of company is Rs. 50 lakh.
(a) Advise company whenever it should include debt or equity to raise its capital.
(b) Name the concept related to this.
(c) Will the company's decision to raise funds from debt or equity will change if company's EBIT becomes 3 lakh.

Answer 1

Company should prefer debt to raise fund as debt is gainful for equity shareholders till ROI > Rate of interest
In the above case $ROI=\frac{EBIT}{Totalincome}\times 100=\frac{7}{50}\times 100=14$%
Interest$=10$%
14> 10 si debt is more suitable
(b) The company is leverage effect or trading on equity
(c) Yes company's decision will change if EBIT becomes 3 lac, because with 3 lac ROI will become less than interest
$ROI=\frac{EBIT}{Totalincome}\times 100=\frac{3}{50}\times 100=6$%
Interest $1=$%
6< 10
So, now company must prefer equity to raise capital