Question

‘Ratan Ltd.’ and ‘Lara Ltd.’ are two companies with each having a capital employed of Rs. 20,00,000. ‘Ratan Ltd.’ had raised funds by issuing shares whereas ‘Lara Ltd.’s capital has 60% equity and 40% debt (8% debentures). Both have ROI of 10% and tax rate is 40%. State with reason which company will give a better return to shareholders.

Hint:

Debt is a "Double-Edged Sword." It increases returns when ROI is high but can lead to bankruptcy if ROI falls below the interest rate.

Answer 1

Step 1: Understanding the Concept:
We need to calculate the Earnings Per Share (EPS). If ROI>Interest Rate, the company benefits from "Trading on Equity" by using debt.
Step 2: Detailed Explanation:
Total Capital = Rs. 20,00,000. EBIT (10% of 20L) = Rs. 2,00,000 for both.
Calculations for Ratan Ltd. (100% Equity):
1. EBIT: Rs. 2,00,000
2. Interest: Rs. 0
3. EBT (1 - 2): Rs. 2,00,000
4. Tax (40%): Rs. 80,000
5. EAT (3 - 4): Rs. 1,20,000
6. No. of Shares (20L / 100): 20,000
7. EPS (5 / 6): Rs. 6.00
Calculations for Lara Ltd. (60% Equity, 40% Debt):
1. EBIT: Rs. 2,00,000
2. Interest (8% of Rs. 8,00,000 debt): Rs. 64,000
3. EBT (1 - 2): Rs. 1,36,000
4. Tax (40%): Rs. 54,400
5. EAT (3 - 4): Rs. 81,600
6. No. of Shares (12L equity / 100): 12,000
7. EPS (5 / 6): Rs. 6.80
Step 3: Final Answer:
Lara Ltd. will give a better return because its ROI (10%) is greater than the cost of debt (8%). This is called "Trading on Equity."