Test 3: Financing Decisions - Capital Structure: answer key

Question 1 · 2 marks · Financing Decisions - Capital Structure · medium

Scenario. Navrang Solar Equipment Ltd. is undertaking a major expansion of its solar inverter manufacturing facility. The board requires ₹300 lakh to establish the additional production capacity and is comparing three alternative financing arrangements. The company has no preference dividend or interest commitment from its existing capital structure that needs to be added to the following plans. Financial information: Particulars | Plan A | Plan B | Plan C Equity shares (lakh) | 30 | 20 | 24 Equity share issue price | ₹10 | ₹10 | ₹10 Long-term debt | Nil | ₹100 lakh | Nil Debt interest rate | Nil | 15% | Nil Preference share capital | Nil | Nil | ₹60 lakh Preference dividend rate | Nil | Nil | 17.50% Annual preference dividend | Nil | Nil | ₹10.50 lakh Annual interest | Nil | ₹15 lakh | Nil Additional financial data: Expected EBIT | ₹60 lakh Corporate tax rate | 30% Risk-free rate | 6% Equity beta | 1.25 Expected market risk premium | 5% Estimated annual operating cash flow after tax, before financing | ₹78 lakh The company operates with a raw-material holding period of 40 days, work-in-process period of 10 days, finished-goods holding period of 20 days, receivables collection period of 55 days and trade-credit period of 35 days. The management uses these periods to assess its liquidity requirements and ability to service fixed financial commitments. Its annual operating earnings are expected to fluctuate between ₹40 lakh and ₹80 lakh, depending on the volume of orders received from solar installation contractors. The finance director has prepared an EBIT-EPS chart to evaluate the three financing arrangements. The board requires the indifference points for the individual pairs of plans and the EPS under the expected operating conditions. All amounts are expressed in lakh rupees, and the stated equity-share numbers represent the total shares outstanding after the proposed financing.

Determine the EBIT-EPS indifference point between Plan A (all equity) and Plan B (equity and debt) of Navrang Solar Equipment Ltd.

1. ₹45 lakh (correct answer)
2. ₹30 lakh
3. ₹60 lakh
4. ₹75 lakh

Answer: A — ₹45 lakh

Explanation. Let EBIT be E. Plan A EPS = E(1 − 0.30)/30. Plan B EPS = (E − 15)(1 − 0.30)/20. Equating the two and cancelling the common tax factor: E/30 = (E − 15)/20. Therefore, 20E = 30E − 450; 10E = 450; E = ₹45 lakh. This is the EBIT at which both plans provide identical EPS. The preference dividend is irrelevant to this comparison because neither plan has preference capital.

Where it goes wrong. Using the amount of debt rather than annual interest as the fixed financial charge, or failing to cancel the identical tax factor correctly.

Authority. ICAI SM: Financial Management and Strategic Management, Financing Decisions - Capital Structure

Question 2 · 2 marks · Financing Decisions - Capital Structure · hard

Calculate the EBIT-EPS indifference point between Plan A and Plan C of Navrang Solar Equipment Ltd., considering the preference dividend as an appropriation from post-tax earnings.

1. ₹60 lakh
2. ₹75 lakh (correct answer)
3. ₹90 lakh
4. ₹45 lakh

Answer: B — ₹75 lakh

Explanation. Plan A EPS = 0.70E/30. Plan C EPS = (0.70E − 10.50)/24. At indifference, 24 × 0.70E = 30 × (0.70E − 10.50). Therefore, 16.80E = 21E − 315; 4.20E = 315; E = ₹75 lakh. Preference dividend is deducted after calculating tax. Option d incorrectly treats the preference dividend as tax-deductible interest, while option a results from an incorrect share denominator.

Where it goes wrong. Deducting preference dividend before tax instead of deducting it from profit after tax.

Authority. ICAI SM: Financial Management and Strategic Management, Financing Decisions - Capital Structure

Question 3 · 2 marks · Financing Decisions - Capital Structure · hard

At the expected EBIT of ₹60 lakh, evaluate the EPS under all three plans of Navrang Solar Equipment Ltd. Which financing plan is financially preferable on the basis of EPS?

1. Plan A; ₹1.575
2. Plan C; ₹1.3125
3. Plan B; ₹1.575 (correct answer)
4. Plan A; ₹1.400

Answer: C — Plan B; ₹1.575

Explanation. Plan A EPS = ₹60 lakh × 70%/30 lakh = ₹1.40. Plan B EPS = (₹60 lakh − ₹15 lakh) × 70%/20 lakh = ₹31.50/20 = ₹1.575. Plan C EPS = (₹42 lakh − ₹10.50 lakh)/24 lakh = ₹31.50/24 = ₹1.3125. Hence Plan B produces the highest EPS of ₹1.575. The expected EBIT exceeds the equity-debt indifference point of ₹45 lakh, making the leveraged plan preferable to Plan A.

Where it goes wrong. Comparing profit after tax before preference dividend, or selecting the plan with fewer equity shares without correctly deducting its fixed financing commitments.

Authority. ICAI SM: Financial Management and Strategic Management, Financing Decisions - Capital Structure

Question 4 · 2 marks · Financing Decisions - Capital Structure · hard

The EBIT-EPS chart of Navrang Solar Equipment Ltd. plots Plan B and Plan C as two straight lines. Determine their point of intersection and the correct relationship between their EPS lines when EBIT exceeds this intersection.

1. ₹45 lakh; Plan C has higher EPS above the intersection
2. ₹75 lakh; Plan C has higher EPS above the intersection
3. ₹60 lakh; Plan B has higher EPS above the intersection
4. ₹15 lakh; Plan B has higher EPS above the intersection (correct answer)

Answer: D — ₹15 lakh; Plan B has higher EPS above the intersection

Explanation. Plan B EPS = 0.70(E − 15)/20 and Plan C EPS = (0.70E − 10.50)/24. Equating: 24 × 0.70(E − 15) = 20 × (0.70E − 10.50). Hence, 16.80E − 252 = 14E − 210; 2.80E = 42; E = ₹15 lakh. Above this point, Plan B has the steeper EPS line because its earnings are divided among fewer equity shares.

Where it goes wrong. Confusing the intersection of the EPS lines with the intersection of the underlying financing amounts, or interpreting the steeper line as the one having lower EPS at higher EBIT.

Authority. ICAI SM: Financial Management and Strategic Management, Financing Decisions - Capital Structure

Question 5 · 2 marks · Financing Decisions - Capital Structure · medium

Scenario. Pragati Mobility Systems Ltd. manufactures transmission components and precision assemblies for electric vehicles. It proposes to establish a new manufacturing unit requiring total long-term finance of ₹300 lakh. The management is evaluating the relative advantages of equity, debt and preference share financing because the proposed facility is expected to operate with substantial fixed manufacturing costs. The company has no existing interest or preference dividend commitments for the purpose of this analysis. Proposed financing alternatives: Particulars | Plan X | Plan Y | Plan Z Equity shares outstanding (lakh) | 15 | 10 | 12 Issue price per equity share | ₹20 | ₹20 | ₹20 Equity capital raised | ₹300 lakh | ₹200 lakh | ₹240 lakh Debenture financing | Nil | ₹100 lakh | Nil Interest rate | Nil | 12% | Nil Annual interest | Nil | ₹12 lakh | Nil Preference capital | Nil | Nil | ₹60 lakh Preference dividend rate | Nil | Nil | 15% Annual preference dividend | Nil | Nil | ₹9 lakh Other operating and financial information: Expected EBIT | ₹48 lakh Corporate tax rate | 25% Risk-free return | 6% Equity beta | 1.30 Expected market risk premium | 5.50% Annual operating cash flow after tax, before financing | ₹62 lakh The plant has a raw-material holding period of 35 days, work-in-process period of 15 days, finished-goods holding period of 25 days, receivables collection period of 65 days and trade-payables period of 40 days. These operational figures are considered while determining the company's liquidity buffer and its capacity to meet fixed financing commitments. Management expects EBIT to vary between ₹25 lakh and ₹75 lakh depending on production utilisation. A comparative EBIT-EPS chart has been prepared, showing the EPS lines of the three plans at different operating-profit levels. The board wants to identify the pairwise indifference points and determine which financing arrangement produces the highest EPS at the anticipated EBIT. For all calculations, interest is deductible before corporate tax, whereas preference dividends are appropriations from post-tax profits.

Calculate the EBIT-EPS indifference point between Plan X (all equity) and Plan Y (equity plus debt) of Pragati Mobility Systems Ltd.

1. ₹36 lakh (correct answer)
2. ₹24 lakh
3. ₹48 lakh
4. ₹60 lakh

Answer: A — ₹36 lakh

Explanation. Let the indifference EBIT be E. EPS under Plan X = 0.75E/15, while Plan Y EPS = 0.75(E − 12)/10. Equating and cancelling 0.75: E/15 = (E − 12)/10. Cross-multiplying gives 10E = 15E − 180. Therefore, 5E = 180 and E = ₹36 lakh. At this operating-profit level, the smaller equity base of Plan Y exactly offsets its annual interest commitment.

Where it goes wrong. Using the total debenture issue amount instead of annual interest, or incorrectly retaining the tax factor on one side after cancelling it on the other.

Authority. ICAI SM: Financial Management and Strategic Management, Financing Decisions - Capital Structure

Question 6 · 2 marks · Financing Decisions - Capital Structure · hard

Determine the EBIT-EPS indifference point between Plan X and Plan Z of Pragati Mobility Systems Ltd. Plan Z carries preference shares with an annual dividend of ₹9 lakh.

1. ₹48 lakh
2. ₹60 lakh (correct answer)
3. ₹36 lakh
4. ₹72 lakh

Answer: B — ₹60 lakh

Explanation. EPS under Plan X = 0.75E/15. EPS under Plan Z = (0.75E − 9)/12. Equating: 12 × 0.75E = 15 × (0.75E − 9). Therefore, 9E = 11.25E − 135; 2.25E = 135; E = ₹60 lakh. The preference dividend is deducted directly from post-tax earnings. It must not be multiplied by the tax factor again.

Where it goes wrong. Applying a tax shield to the preference dividend or using preference capital as the denominator instead of the number of equity shares.

Authority. ICAI SM: Financial Management and Strategic Management, Financing Decisions - Capital Structure

Question 7 · 2 marks · Financing Decisions - Capital Structure · hard

At the expected EBIT of ₹48 lakh, calculate EPS under each financing plan and identify the plan that gives the maximum EPS.

1. Plan X; ₹2.25
2. Plan Z; ₹2.70
3. Plan Y; ₹2.70 (correct answer)
4. Plan X; ₹2.40

Answer: C — Plan Y; ₹2.70

Explanation. Plan X EPS = ₹48 lakh × 75%/15 lakh = ₹2.40. Plan Y EPS = (₹48 lakh − ₹12 lakh) × 75%/10 lakh = ₹27 lakh/10 lakh = ₹2.70. Plan Z EPS = (₹36 lakh − ₹9 lakh)/12 lakh = ₹2.25. Thus Plan Y gives the highest EPS of ₹2.70. Its advantage arises because expected EBIT exceeds its indifference point with Plan X.

Where it goes wrong. Ignoring the preference dividend under Plan Z or assuming that all equity financing always produces the highest EPS irrespective of the expected EBIT.

Authority. ICAI SM: Financial Management and Strategic Management, Financing Decisions - Capital Structure

Question 8 · 2 marks · Financing Decisions - Capital Structure · hard

Calculate the intersection point of the EPS lines of Plan Y and Plan Z on the EBIT-EPS chart. Which plan produces higher EPS when EBIT is above this intersection?

1. ₹36 lakh; Plan Z
2. ₹24 lakh; Plan Y
3. ₹60 lakh; Plan Z
4. ₹12 lakh; Plan Y (correct answer)

Answer: D — ₹12 lakh; Plan Y

Explanation. Plan Y EPS = 0.75(E − 12)/10. Plan Z EPS = (0.75E − 9)/12. Equating: 12 × 0.75(E − 12) = 10 × (0.75E − 9). Thus, 9E − 108 = 7.50E − 90; 1.50E = 18; E = ₹12 lakh. Above the intersection, Plan Y has the greater EPS because its number of equity shares is lower and its EPS line has a steeper slope.

Where it goes wrong. Comparing the annual interest and preference dividend without accounting for their respective equity-share denominators.

Authority. ICAI SM: Financial Management and Strategic Management, Financing Decisions - Capital Structure

Question 9 · 2 marks · Financing Decisions - Capital Structure · medium

Scenario. A company is considering two alternative financing plans. Plan A consists of 12 lakh equity shares and no debt. Plan B consists of 8 lakh equity shares and debentures carrying annual interest of ₹16 lakh. If the corporate tax rate is 25%, calculate the EBIT-EPS indifference point.

A company is considering two alternative financing plans. Plan A consists of 12 lakh equity shares and no debt. Plan B consists of 8 lakh equity shares and debentures carrying annual interest of ₹16 lakh. If the corporate tax rate is 25%, calculate the EBIT-EPS indifference point.

1. ₹48 lakh (correct answer)
2. ₹32 lakh
3. ₹64 lakh
4. ₹80 lakh

Answer: A — ₹48 lakh

Explanation. Plan A EPS = 0.75E/12. Plan B EPS = 0.75(E − 16)/8. Equating and cancelling the tax factor: E/12 = (E − 16)/8. Therefore, 8E = 12E − 192; 4E = 192; E = ₹48 lakh. This is the point where both equity structures provide identical earnings per share. The interest charge must be calculated annually rather than using the principal amount of debentures.

Where it goes wrong. Using the principal amount of debt instead of annual interest when determining the EBIT-EPS indifference point.

Authority. ICAI SM: Financial Management and Strategic Management, Financing Decisions - Capital Structure

Question 10 · 2 marks · Financing Decisions - Capital Structure · medium

Scenario. An enterprise is comparing an all-equity plan with a preference-share financing plan. Plan A has 20 lakh equity shares. Plan B has 15 lakh equity shares and an annual preference dividend of ₹9 lakh. The corporate tax rate is 25%. Calculate the EBIT-EPS indifference point.

An enterprise is comparing an all-equity plan with a preference-share financing plan. Plan A has 20 lakh equity shares. Plan B has 15 lakh equity shares and an annual preference dividend of ₹9 lakh. The corporate tax rate is 25%. Calculate the EBIT-EPS indifference point.

1. ₹36 lakh
2. ₹48 lakh (correct answer)
3. ₹60 lakh
4. ₹72 lakh

Answer: B — ₹48 lakh

Explanation. Plan A EPS = 0.75E/20. Plan B EPS = (0.75E − 9)/15. Equating gives 15 × 0.75E = 20 × (0.75E − 9). Therefore, 11.25E = 15E − 180; 3.75E = 180; E = ₹48 lakh. Preference dividend is an appropriation of profit after tax and is therefore deducted separately from the numerator. The tax factor remains applicable to EBIT earnings.

Where it goes wrong. Deducting preference dividend before tax or incorrectly cancelling the tax factor when preference dividend is present in only one financing plan.

Authority. ICAI SM: Financial Management and Strategic Management, Financing Decisions - Capital Structure

Question 11 · 2 marks · Financing Decisions - Capital Structure · hard

Scenario. A company is evaluating Plan D, consisting of 12 lakh equity shares and annual interest of ₹30 lakh, and Plan P, consisting of 16 lakh equity shares and an annual preference dividend of ₹16 lakh. If the corporate tax rate is 20%, calculate the EBIT-EPS indifference point between the two plans.

A company is evaluating Plan D, consisting of 12 lakh equity shares and annual interest of ₹30 lakh, and Plan P, consisting of 16 lakh equity shares and an annual preference dividend of ₹16 lakh. If the corporate tax rate is 20%, calculate the EBIT-EPS indifference point between the two plans.

1. ₹45 lakh
2. ₹75 lakh
3. ₹60 lakh (correct answer)
4. ₹90 lakh

Answer: C — ₹60 lakh

Explanation. Plan D EPS = 0.80(E − 30)/12. Plan P EPS = (0.80E − 16)/16. Equating: 16 × 0.80(E − 30) = 12 × (0.80E − 16). Hence, 12.80E − 384 = 9.60E − 192; 3.20E = 192; E = ₹60 lakh. Both interest and preference dividends must be treated according to their distinct tax treatment.

Where it goes wrong. Treating preference dividend as an interest expense and deducting it before tax, thereby producing an incorrect EPS equation.

Authority. ICAI SM: Financial Management and Strategic Management, Financing Decisions - Capital Structure

Question 12 · 2 marks · Financing Decisions - Capital Structure · hard

Scenario. A company is comparing two mixed financing plans. Plan M has 12 lakh equity shares, annual interest of ₹12 lakh and annual preference dividend of ₹6 lakh. Plan N has 8 lakh equity shares and annual interest of ₹20 lakh. If the corporate tax rate is 25%, calculate the EBIT-EPS indifference point.

A company is comparing two mixed financing plans. Plan M has 12 lakh equity shares, annual interest of ₹12 lakh and annual preference dividend of ₹6 lakh. Plan N has 8 lakh equity shares and annual interest of ₹20 lakh. If the corporate tax rate is 25%, calculate the EBIT-EPS indifference point.

1. ₹15 lakh
2. ₹25 lakh
3. ₹30 lakh
4. ₹20 lakh (correct answer)

Answer: D — ₹20 lakh

Explanation. Plan M EPS = [0.75(E − 12) − 6]/12 = 0.0625E − 1.25. Plan N EPS = 0.75(E − 20)/8 = 0.09375E − 1.875. Equating: 0.0625E − 1.25 = 0.09375E − 1.875. Therefore, 0.03125E = 0.625; E = ₹20 lakh. Preference dividend must be deducted after tax, unlike interest.

Where it goes wrong. Applying the tax shield to preference dividend or omitting the preference dividend while calculating earnings available to ordinary shareholders.

Authority. ICAI SM: Financial Management and Strategic Management, Financing Decisions - Capital Structure

Question 13 · 2 marks · Financing Decisions - Capital Structure · medium

Scenario. Three financing alternatives are available to a company at an expected EBIT of ₹48 lakh. Plan A comprises 10 lakh equity shares without fixed financial charges. Plan B comprises 8 lakh equity shares with annual interest of ₹12 lakh. Plan C comprises 9 lakh equity shares with an annual preference dividend of ₹9 lakh. The corporate tax rate is 30%. Which plan produces the highest EPS?

Three financing alternatives are available to a company at an expected EBIT of ₹48 lakh. Plan A comprises 10 lakh equity shares without fixed financial charges. Plan B comprises 8 lakh equity shares with annual interest of ₹12 lakh. Plan C comprises 9 lakh equity shares with an annual preference dividend of ₹9 lakh. The corporate tax rate is 30%. Which plan produces the highest EPS?

1. Plan A; ₹3.36 (correct answer)
2. Plan B; ₹3.36
3. Plan C; ₹2.73
4. Plan B; ₹3.15

Answer: A — Plan A; ₹3.36

Explanation. Plan A EPS = ₹48 lakh × 70%/10 lakh = ₹3.36. Plan B EPS = (₹48 lakh − ₹12 lakh) × 70%/8 lakh = ₹25.20 lakh/8 lakh = ₹3.15. Plan C EPS = (₹33.60 lakh − ₹9 lakh)/9 lakh = ₹2.7333. Plan A therefore provides the highest EPS. The preference dividend is deducted after tax, while interest reduces taxable earnings.

Where it goes wrong. Calculating preference-plan EPS using profit after tax before preference dividend, or assuming fewer shares automatically guarantee higher EPS.

Authority. ICAI SM: Financial Management and Strategic Management, Financing Decisions - Capital Structure

Question 14 · 2 marks · Financing Decisions - Capital Structure · hard

Scenario. An all-equity plan consists of 12 lakh equity shares. An alternative plan consists of 8 lakh equity shares and preference share capital of ₹160 lakh. The two plans have an EBIT-EPS indifference point of ₹60 lakh. If the corporate tax rate is 20%, determine the annual preference dividend rate under the alternative plan.

An all-equity plan consists of 12 lakh equity shares. An alternative plan consists of 8 lakh equity shares and preference share capital of ₹160 lakh. The two plans have an EBIT-EPS indifference point of ₹60 lakh. If the corporate tax rate is 20%, determine the annual preference dividend rate under the alternative plan.

1. 8%
2. 10% (correct answer)
3. 12%
4. 15%

Answer: B — 10%

Explanation. Let annual preference dividend be PD. At EBIT ₹60 lakh, all-equity EPS = ₹60 lakh × 80%/12 lakh = ₹4. Under the preference plan, EPS = (₹48 lakh − PD)/8 lakh. Equating: ₹48 lakh − PD = ₹32 lakh. Therefore PD = ₹16 lakh. Preference dividend rate = ₹16 lakh/₹160 lakh × 100 = 10%. The dividend is deducted from post-tax profits and is not tax-deductible.

Where it goes wrong. Applying the tax factor to preference dividend when solving for the unknown dividend rate.

Authority. ICAI SM: Financial Management and Strategic Management, Financing Decisions - Capital Structure

Question 15 · 2 marks · Financing Decisions - Capital Structure · hard

Scenario. A company requires ₹360 lakh to finance a new project. Under Plan I, the entire amount is raised by issuing equity shares at ₹30 per share. Under Plan II, ₹180 lakh is raised through equity shares issued at ₹30 per share and the remaining ₹180 lakh through 12% debentures. The corporate tax rate is 25%. Determine the EBIT-EPS indifference point between the two plans.

A company requires ₹360 lakh to finance a new project. Under Plan I, the entire amount is raised by issuing equity shares at ₹30 per share. Under Plan II, ₹180 lakh is raised through equity shares issued at ₹30 per share and the remaining ₹180 lakh through 12% debentures. The corporate tax rate is 25%. Determine the EBIT-EPS indifference point between the two plans.

1. ₹36 lakh
2. ₹48 lakh
3. ₹43.20 lakh (correct answer)
4. ₹54 lakh

Answer: C — ₹43.20 lakh

Explanation. Plan I shares = ₹360 lakh/₹30 = 12 lakh shares. Plan II shares = ₹180 lakh/₹30 = 6 lakh shares. Annual interest under Plan II = ₹180 lakh × 12% = ₹21.60 lakh. Equating EPS: 0.75E/12 = 0.75(E − 21.60)/6. Cancelling 0.75: E/12 = (E − 21.60)/6. Hence 6E = 12E − 259.20; E = ₹43.20 lakh.

Where it goes wrong. Calculating the number of shares using face value instead of the actual issue price, or confusing total debenture financing with annual interest.

Authority. ICAI SM: Financial Management and Strategic Management, Financing Decisions - Capital Structure

Question 16 · 2 marks · Financing Decisions - Capital Structure · hard

Scenario. Two alternative financing arrangements have identical equity share capital consisting of 10 lakh shares each. Plan D carries annual interest of ₹12 lakh, whereas Plan P carries annual preference dividend of ₹10 lakh. The corporate tax rate is 25%. Which conclusion is correct regarding their EBIT-EPS indifference point?

Two alternative financing arrangements have identical equity share capital consisting of 10 lakh shares each. Plan D carries annual interest of ₹12 lakh, whereas Plan P carries annual preference dividend of ₹10 lakh. The corporate tax rate is 25%. Which conclusion is correct regarding their EBIT-EPS indifference point?

1. The indifference point is ₹40 lakh.
2. The indifference point is ₹50 lakh.
3. The indifference point is ₹80 lakh.
4. No indifference point exists; Plan D produces higher EPS at every EBIT level. (correct answer)

Answer: D — No indifference point exists; Plan D produces higher EPS at every EBIT level.

Explanation. Plan D earnings available to equity = 0.75E − (12 × 0.75) = 0.75E − ₹9 lakh. Plan P earnings available = 0.75E − ₹10 lakh. Both plans have 10 lakh shares. Hence Plan D EPS is always ₹1 lakh/10 lakh shares = ₹0.10 higher for every EBIT level. Since the share count is identical and the effective after-tax fixed charges differ, no indifference point exists.

Where it goes wrong. Assuming every pair of financial plans must have an indifference point, even when both plans have identical equity shares but different effective fixed financial charges.

Authority. ICAI SM: Financial Management and Strategic Management, Financing Decisions - Capital Structure

Question 17 · 2 marks · Financing Decisions - Capital Structure · medium

Scenario. A company is preparing an EBIT-EPS chart for a financing plan consisting of 8 lakh equity shares and annual interest of ₹16 lakh. The corporate tax rate is 25%. Determine the EPS at EBIT of ₹40 lakh and the EBIT-axis intercept of the EPS line.

A company is preparing an EBIT-EPS chart for a financing plan consisting of 8 lakh equity shares and annual interest of ₹16 lakh. The corporate tax rate is 25%. Determine the EPS at EBIT of ₹40 lakh and the EBIT-axis intercept of the EPS line.

1. EPS ₹2.25; EBIT-axis intercept ₹16 lakh (correct answer)
2. EPS ₹3.00; EBIT-axis intercept ₹12 lakh
3. EPS ₹2.50; EBIT-axis intercept ₹20 lakh
4. EPS ₹1.50; EBIT-axis intercept ₹16 lakh

Answer: A — EPS ₹2.25; EBIT-axis intercept ₹16 lakh

Explanation. EPS = 0.75(EBIT − Interest)/Number of shares. At EBIT ₹40 lakh, EPS = 0.75(40 − 16)/8 = ₹18 lakh/8 lakh = ₹2.25. The EBIT-axis intercept occurs when EPS is zero, which requires EBIT to equal the fixed interest charge of ₹16 lakh. Therefore, the EPS line crosses the horizontal EBIT axis at ₹16 lakh. Its vertical-axis intercept is negative ₹1.50.

Where it goes wrong. Confusing the EBIT-axis intercept with the vertical-axis intercept or ignoring interest while determining the financial break-even point.

Authority. ICAI SM: Financial Management and Strategic Management, Financing Decisions - Capital Structure

Question 18 · 2 marks · Financing Decisions - Capital Structure · hard

Scenario. A company has proposed a financing plan involving annual debt interest of ₹18 lakh and annual preference dividend of ₹12 lakh. The corporate tax rate is 25%. Calculate the financial break-even point of the company.

A company has proposed a financing plan involving annual debt interest of ₹18 lakh and annual preference dividend of ₹12 lakh. The corporate tax rate is 25%. Calculate the financial break-even point of the company.

1. ₹30 lakh
2. ₹34 lakh (correct answer)
3. ₹36 lakh
4. ₹40 lakh

Answer: B — ₹34 lakh

Explanation. Financial break-even EBIT is the minimum EBIT required to meet all fixed financial charges and leave zero earnings for ordinary shareholders. Formula: Financial BEP = Interest + Preference dividend/(1 − tax rate). Substituting: ₹18 lakh + ₹12 lakh/0.75 = ₹18 lakh + ₹16 lakh = ₹34 lakh. Interest is deducted before tax, whereas preference dividend must be grossed up to its pre-tax equivalent.

Where it goes wrong. Simply adding interest and preference dividend without grossing up preference dividend for the corporate tax rate.

Authority. ICAI SM: Financial Management and Strategic Management, Financing Decisions - Capital Structure

Question 19 · 2 marks · Financing Decisions - Capital Structure · hard

Scenario. A company is considering Plan A comprising 20 lakh equity shares and Plan B comprising 12 lakh equity shares with annual interest of ₹20 lakh. The corporate tax rate is 25%. The management expects EBIT of ₹42 lakh. Determine the indifference point and the preferred financing plan at the expected EBIT.

A company is considering Plan A comprising 20 lakh equity shares and Plan B comprising 12 lakh equity shares with annual interest of ₹20 lakh. The corporate tax rate is 25%. The management expects EBIT of ₹42 lakh. Determine the indifference point and the preferred financing plan at the expected EBIT.

1. ₹40 lakh; Plan B
2. ₹60 lakh; Plan B
3. ₹50 lakh; Plan A (correct answer)
4. ₹45 lakh; Plan A

Answer: C — ₹50 lakh; Plan A

Explanation. Indifference equation: 0.75E/20 = 0.75(E − 20)/12. Cancelling the tax factor: E/20 = (E − 20)/12. Therefore, 12E = 20E − 400; E = ₹50 lakh. Expected EBIT of ₹42 lakh is below this point, so Plan A is preferable. Plan A EPS = 0.75 × 42/20 = ₹1.575, while Plan B EPS = 0.75 × 22/12 = ₹1.375.

Where it goes wrong. Selecting the debt-financed alternative below the EBIT-EPS indifference point without calculating the relative impact of interest on equity earnings.

Authority. ICAI SM: Financial Management and Strategic Management, Financing Decisions - Capital Structure

Question 20 · 2 marks · Financing Decisions - Capital Structure · hard

Scenario. A company is comparing two financing alternatives. Plan P has 16 lakh equity shares, annual interest of ₹8 lakh and annual preference dividend of ₹6 lakh. Plan Q has 10 lakh equity shares and annual interest of ₹22 lakh. The corporate tax rate is 25%. Determine the EBIT-EPS indifference point and identify the superior plan at an expected EBIT of ₹40 lakh.

A company is comparing two financing alternatives. Plan P has 16 lakh equity shares, annual interest of ₹8 lakh and annual preference dividend of ₹6 lakh. Plan Q has 10 lakh equity shares and annual interest of ₹22 lakh. The corporate tax rate is 25%. Determine the EBIT-EPS indifference point and identify the superior plan at an expected EBIT of ₹40 lakh.

1. ₹24 lakh; Plan P
2. ₹40 lakh; Plan P
3. ₹30 lakh; Plan Q
4. ₹32 lakh; Plan Q (correct answer)

Answer: D — ₹32 lakh; Plan Q

Explanation. Plan P EPS = [0.75(E − 8) − 6]/16 = (0.75E − 12)/16. Plan Q EPS = 0.75(E − 22)/10 = (0.75E − 16.50)/10. Equating: 10(0.75E − 12) = 16(0.75E − 16.50). Therefore, 7.50E − 120 = 12E − 264; E = ₹32 lakh. At EBIT ₹40 lakh, Plan P EPS = ₹18/16 = ₹1.125 and Plan Q EPS = ₹13.50/10 = ₹1.35. Plan Q is superior.

Where it goes wrong. Incorrectly treating preference dividends as tax-deductible interest or comparing total fixed charges without accounting for different equity-share denominators.

Authority. ICAI SM: Financial Management and Strategic Management, Financing Decisions - Capital Structure