Question

A company’s earnings before interest and tax is Rs. 7 lakhs. It pays 10% interest on its debt. Total investment of company is rs. 50 lakhs.

1. Advise company whenever it should include debt or equity to raise its capital.

2. Name the concept related to this.

3. Will be company’s decision to raise funds from debt or equity will change if company’s EBIT becomes 3 lakhs

Answer 1

1. Company should prefer debt to raise fund as debt is gainful for equity shareholders’ till

ROI > Rate of Interest.

In the above case ROI = EBIT × 100

Total Income = 7 × 100 = 14%

14 > 10 so debt it more suitable.

2. The concept is leverage effect or trading in equity.

3. Yes company’s decision will change if EBIT becomes 3 lac, because with 3 lac ROI will become less than interest.

ROI = EBIT × 100 = 3 × 100 = 6%

Total Income 50

Interest = 10%

6% < 10%

So, now company must prefer equity to raise capital.