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

Concept: To evaluate which company provides a better return to its shareholders, we need to calculate the Earnings Per Share (EPS) for both firms. This scenario illustrates the concept of Trading on Equity (or financial leverage), where a company uses fixed-interest debt to boost returns for equity shareholders. Trading on equity increases EPS only when the Return on Investment (ROI) is higher than the interest rate on debt. Let us summarize the given parameters and perform the financial calculations for both companies.

• Total Capital Employed for both companies \(= \text{₹ } 20,00,000\)

• Return on Investment (ROI) \(= 10\%\)

• Earnings Before Interest and Taxes (EBIT) \(= 10\% \text{ of Capital Employed} = \frac{10}{100} \times 20,00,000 = \text{₹ } 2,00,000\)

• Corporate Tax Rate \(= 40\%\)
Step 1: Financial Analysis of 'Ratan Ltd.' (100% Equity Capital)
Ratan Ltd. uses no debt in its capital structure.

• Equity Share Capital \(= \text{₹ } 20,00,000\)

• Total number of Equity Shares (\(\text{at ₹ } 100 \text{ each}\)) \(= \frac{20,00,000}{100} = 20,000 \text{ shares}\)

• Interest Expense \(= 0\) (Since there is no debt)
Let us calculate the Earnings After Tax (EAT) and EPS for Ratan Ltd.: \[ \text{EBIT} = \text{₹ } 2,00,000 \] \[ \text{Less: Interest} = 0 \] \[ \text{Earnings Before Tax (EBT)} = \text{₹ } 2,00,000 \] \[ \text{Less: Tax @ 40\%} = 40\% \text{ of } 2,00,000 = \text{₹ } 80,000 \] \[ \text{Earnings After Tax (EAT)} = 2,00,000 - 80,000 = \text{₹ } 1,20,000 \] \[ \text{Earnings Per Share (EPS)} = \frac{\text{Earnings After Tax (EAT)}}{\text{Total Number of Equity Shares}} = \frac{1,20,000}{20,000} = \text{₹ } 6.00 \]

Step 2: Financial Analysis of 'Lara Ltd.' (60% Equity and 40% Debt)
Lara Ltd. uses a mix of debt and equity capital.

• Debt Component \(= 40\% \text{ of } 20,00,000 = \text{₹ } 8,00,000\)

• Interest Rate on Debentures \(= 8\%\)

• Annual Interest Expense \(= 8\% \text{ of } 8,00,000 = \frac{8}{100} \times 8,00,000 = \text{₹ } 64,000\)

• Equity Capital Component \(= 60\% \text{ of } 20,00,000 = \text{₹ } 12,00,000\)

• Total number of Equity Shares (\(\text{at ₹ } 100 \text{ each}\)) \(= \frac{12,00,000}{100} = 12,00,000 / 100 = 12,000 \text{ shares}\)
Let us calculate the Earnings After Tax (EAT) and EPS for Lara Ltd.: \[ \text{EBIT} = \text{₹ } 2,00,000 \] \[ \text{Less: Interest Expense} = \text{₹ } 64,000 \] \[ \text{Earnings Before Tax (EBT)} = 2,00,000 - 64,000 = \text{₹ } 1,36,000 \] \[ \text{Less: Tax @ 40\%} = 40\% \text{ of } 1,36,000 = \frac{40}{100} \times 1,36,000 = \text{₹ } 54,400 \] \[ \text{Earnings After Tax (EAT)} = 1,36,000 - 54,400 = \text{₹ } 81,600 \] \[ \text{Earnings Per Share (EPS)} = \frac{\text{Earnings After Tax (EAT)}}{\text{Total Number of Equity Shares}} = \frac{81,600}{12,000} = \text{₹ } 6.80 \]

Step 3: Comparative Summary and Final Assessment
Let us organize the calculated metrics in a comparative table for a clear overview: tabular|p5.5cm|p3.5cm|p3.5cm| Financial Metrics & Ratan Ltd. & Lara Ltd.
Capital Structure Composition & 100% Equity & 60% Equity + 40% Debt
Earnings Before Interest & Taxes (EBIT) & ₹ 2,00,000 & ₹ 2,00,000
Less: Interest Paid & Nil & (₹ 64,000)
Earnings Before Tax (EBT) & ₹ 2,00,000 & ₹ 1,36,000
Less: Corporate Tax @ 40% & (₹ 80,000) & (₹ 54,400)
Earnings After Tax (EAT) & ₹ 1,20,000 & ₹ 81,600
Total Number of Shares & 20,000 shares & 12,000 shares
Earnings Per Share (EPS) & ₹ 6.00 & ₹ 6.80
tabular Conclusion and Reason: Lara Ltd. provides a better return to its shareholders, achieving an EPS of ₹ 6.80 compared to Ratan Ltd.’s EPS of ₹ 6.00. The underlying reason for this difference is that Lara Ltd. successfully benefited from Trading on Equity. This occurs because the company's Return on Investment (10%) is higher than the interest rate on its debt (8%). When a company's rate of return exceeds the cost of its borrowed funds, using debt reduces the tax burden (since interest is a tax-deductible expense) and boosts the earnings available to equity shareholders across a smaller base of shares.