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.
‘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.
Show Hint
Remember: Whenever ROI > Rate of Interest, injecting debt into the capital structure will always increase the EPS for shareholders.
Updated On: Jun 25, 2026
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Correct Answer: 8
Solution and Explanation
Step 1: Concept
Trading on Equity / Financial Leverage.
Step 2: Meaning
Financial leverage refers to the use of fixed-cost debt in the capital structure to increase the earnings per share (EPS) for equity shareholders, provided that the Return on Investment (ROI) is greater than the cost of debt.
Step 3: Analysis
Let's calculate the Earnings Per Share (EPS) for both companies. * Common Data: Total Capital = ₹20,00,000; ROI = 10%; Tax Rate = 40%. * Earnings Before Interest and Tax (EBIT) = 10% of ₹20,00,000 = ₹2,00,000.
Ratan Ltd. (100% Equity):
• Equity Capital = ₹20,00,000 (No. of shares = 20,000 at ₹100 each)
• EBIT = ₹2,00,000
• Less: Interest = ₹0
• Earnings Before Tax (EBT) = ₹2,00,000
• Less: Tax @ 40% = ₹80,000
• Earnings After Tax (EAT) = ₹1,20,000
• EPS = EAT / No. of Shares = ₹1,20,000 / 20,000 =
₹6.00
Lara Ltd. (60% Equity, 40% Debt):
• Equity Capital = ₹12,00,000 (No. of shares = 12,000 at ₹100 each)
• 8% Debt = ₹8,00,000
• EBIT = ₹2,00,000
• Less: Interest (8% of 8,00,000) = ₹64,000
• Earnings Before Tax (EBT) = ₹1,36,000
• Less: Tax @ 40% = ₹54,400
• Earnings After Tax (EAT) = ₹81,600
• EPS = EAT / No. of Shares = ₹81,600 / 12,000 =
₹6.80
Step 4: Conclusion
Lara Ltd. will give a better return (EPS of ₹6.80 compared to ₹6.00) because its Return on Investment (10%) is higher than its Cost of Debt (8%), making Trading on Equity favorable.
Final Answer: Lara Ltd. will give a better return due to favorable financial leverage.
Trading on Equity / Financial Leverage.
Step 2: Meaning
Financial leverage refers to the use of fixed-cost debt in the capital structure to increase the earnings per share (EPS) for equity shareholders, provided that the Return on Investment (ROI) is greater than the cost of debt.
Step 3: Analysis
Let's calculate the Earnings Per Share (EPS) for both companies. * Common Data: Total Capital = ₹20,00,000; ROI = 10%; Tax Rate = 40%. * Earnings Before Interest and Tax (EBIT) = 10% of ₹20,00,000 = ₹2,00,000.
Ratan Ltd. (100% Equity):
• Equity Capital = ₹20,00,000 (No. of shares = 20,000 at ₹100 each)
• EBIT = ₹2,00,000
• Less: Interest = ₹0
• Earnings Before Tax (EBT) = ₹2,00,000
• Less: Tax @ 40% = ₹80,000
• Earnings After Tax (EAT) = ₹1,20,000
• EPS = EAT / No. of Shares = ₹1,20,000 / 20,000 =
₹6.00
Lara Ltd. (60% Equity, 40% Debt):
• Equity Capital = ₹12,00,000 (No. of shares = 12,000 at ₹100 each)
• 8% Debt = ₹8,00,000
• EBIT = ₹2,00,000
• Less: Interest (8% of 8,00,000) = ₹64,000
• Earnings Before Tax (EBT) = ₹1,36,000
• Less: Tax @ 40% = ₹54,400
• Earnings After Tax (EAT) = ₹81,600
• EPS = EAT / No. of Shares = ₹81,600 / 12,000 =
₹6.80
Step 4: Conclusion
Lara Ltd. will give a better return (EPS of ₹6.80 compared to ₹6.00) because its Return on Investment (10%) is higher than its Cost of Debt (8%), making Trading on Equity favorable.
Final Answer: Lara Ltd. will give a better return due to favorable financial leverage.
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