CBSE 2025, BS Set 1

Question

A company, 'SK Energy Ltd.' is providing solar energy solutions in some states of the country. Now it wants to expand its operations in some other states also. It needs ₹ 30,00,000 for its expansion. The Chief Financial Officer suggested two options for this.

**Option I:** To raise the entire funds through issue of shares of ₹ 10 each.

**Option II:** To raise ₹ 10,00,000 through issue of shares of ₹ 10 each and ₹ 20,00,000 by raising debt @ 10% p.a.

The return on investment of the firm is 12% and tax rate is 30%.

(i) Which of the two options will maximise shareholders' wealth? Give reason in support of your answer.

(ii) Will the earning per share improve if return on investment of the company is 8%? Give reason in support of your answer. Show your working clearly.

Edvaya · Accepted Answer

The correct answer is Subjective. **(i) Option II will maximise shareholders' wealth.** **Reason — Trading on Equity (Financial Leverage):** When ROI (12%) > Cost of Debt (10%), using debt is beneficial. After tax, the effective cost of debt = 10% × (1 - 0.30) = **7%**. Since ROI (12%) > After-tax cost of debt (7%), the excess returns generated belong to equity shareholders, increasing their EPS. **Working:** | Particulars | Option I (All Equity) | Option II (Mix) | |---|---|---| | Total Funds | ₹30,00,000 | ₹30,00,000 | | Equity | ₹30,00,000 | ₹10,00,000 | | Debt @ 10% | — | ₹20,00,000 | | EBIT (12% on ₹30,00,000) | ₹3,60,000 | ₹3,60,000 | | Less: Interest (10% on debt) | — | ₹2,00,000 | | EBT | ₹3,60,000 | ₹1,60,000 | | Less: Tax @ 30% | ₹1,08,000 | ₹48,000 | | EAT | ₹2,52,000 | ₹1,12,000 | | No. of Shares (₹10 each) | 3,00,000 | 1,00,000 | | **EPS** | **₹0.84** | **₹1.12** | **Conclusion:** Option II gives a higher EPS of ₹1.12 vs ₹0.84, so it maximises shareholders' wealth. **(ii) No, EPS will NOT improve under Option II if ROI = 8%.** **Reason:** When ROI (8%) < Cost of Debt (10%), using debt becomes a disadvantage. The company earns less than it pays for debt, resulting in lower EPS for Option II than Option I. **Working (ROI = 8%):** | Particulars | Option I | Option II | |---|---|---| | EBIT (8% on ₹30,00,000) | ₹2,40,000 | ₹2,40,000 | | Less: Interest | — | ₹2,00,000 | | EBT | ₹2,40,000 | ₹40,000 | | Less: Tax @ 30% | ₹72,000 | ₹12,000 | | EAT | ₹1,68,000 | ₹28,000 | | No. of Shares | 3,00,000 | 1,00,000 | | **EPS** | **₹0.56** | **₹0.28** | **Conclusion:** At ROI = 8%, Option II gives EPS of ₹0.28 vs ₹0.56 for Option I. EPS does NOT improve under Option II — it is lower. Therefore, financial leverage works against shareholders when ROI < cost of debt.

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