Question

There are two companies B and D. Total contribution of capital is Rs.40 lakhs each. The proportion of equity in the total capital of the company B is Rs. 10 lakhs and debt is Rs.30 lakhs. While in company D, the total equity capital is Rs.40 lakhs, sourced through equity. EBIT is Rs.8 lakhs, the interest rate on debt is @ 10% and the tax rate is 30%. Which company enjoys the favourbale financial leverage?

• A. Company B
• B. Company D
• C. Both B & D
• D. None of the above

Answer 1

Answer: (A), (C)

The correct options are
A

Company B

C

Both B & D

As per the above furnished details, we need to decide which company enjoys the favourable financial leverage.

$\begin{array}{ccc}& \text{Company B}& \text{Company D}\\ \text{Equity@100 each}& \text{Rs.1000000}& \text{Rs.400000}\\ \text{Loan@10 \% p.a}& \text{Rs.3000000}& -\\ \text{Total Capital}& \text{Rs.4000000}& \text{Rs.400000}\\ \text{EBIT}& \text{Rs.8000000}& \text{Rs.800000}\\ \text{(-)Interest@ 10 \%}& \text{Rs.3000000}& -\\ \text{EBT}& \text{Rs.5000000}& \text{Rs.800000}\\ \text{(-)Tax @ 30}& \text{Rs.150000}& \text{Rs.240000}\\ & \text{Rs.350000}& \text{Rs.560000}\\ \text{EPS}& 35\%& 14\%\end{array}$

Company B is in the position of favourable financial leverage as use of debt increases the EPS and thus the situation is considered as favourable for trading on equity.