question_answer

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

Answer:

As per the given details, company enjoying the favourable financial leverage can be identified as below:

Particulars	Company B (Rs.)	Company D (Rs.)
Equity @ Rs. 100 each Loan @ 10% p.a.	10,00,000 30,00,000	40,00,000 ???
Total Capital	40,00,000	40,00,000
EBIT	8,00,000	8,00,000
(??) Interest @ 10%	(3,00,000)	??
EBT (??) Taxt @ 30%	5,00,000 (1,50,000)	8,00,000 (2,40,000)
	3,50,000	5,60,000
EPS	35%	14%

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.