Leverage Before the Price War
Sunrise Packaging, a small unit near Bongaigaon, needs ₹40 lakh to install a corrugated-box plant. Expected annual EBIT is ₹8 lakh. The promoter is considering three financing plans: Plan A, ₹40 lakh equity; Plan B, ₹20 lakh equity and ₹20 lakh 12 per cent debt; Plan C, ₹10 lakh equity and ₹30 lakh 12 per cent debt. Equity shares have a face value of ₹10, and the company will issue shares at par. The tax rate is 30 per cent. The promoter's family holds 60 per cent of the equity in Plan A and wants to keep control. A competitor has just cut box prices by 8 per cent, and bank deposit rates are 7 per cent. The banker asks what happens if EBIT falls to ₹4 lakh.
1. Compute the number of equity shares and EPS under Plans A, B and C.
Read the worked answer
Shares: A = ₹40,00,000 ÷ ₹10 = 4,00,000; B = 2,00,000; C = 1,00,000.
| Plan | EBIT | Interest | PBT | Tax @30% | PAT | Shares | EPS |
|---|---|---|---|---|---|---|---|
| A | 8,00,000 | 0 | 8,00,000 | 2,40,000 | 5,60,000 | 4,00,000 | ₹1.40 |
| B | 8,00,000 | 2,40,000 | 5,60,000 | 1,68,000 | 3,92,000 | 2,00,000 | ₹1.96 |
| C | 8,00,000 | 3,60,000 | 4,40,000 | 1,32,000 | 3,08,000 | 1,00,000 | ₹3.08 |
At the expected EBIT, Plan C gives the highest EPS because the return on investment (₹8 lakh ÷ ₹40 lakh = 20%) exceeds the 12% cost of debt. This is favourable financial leverage, or trading on equity: debt earns more than it costs, and the surplus belongs to fewer shareholders.
2. Which plan would you recommend? Use control, financial risk and the EBIT fall to ₹4 lakh in your reasoning.
Read the worked answer
At EBIT ₹4 lakh:
- A: PBT 4,00,000; tax 1,20,000; PAT 2,80,000; EPS ₹0.70.
- B: interest 2,40,000; PBT 1,60,000; tax 48,000; PAT 1,12,000; EPS ₹0.56.
- C: interest 3,60,000; PBT 40,000; tax 12,000; PAT 28,000; EPS ₹0.28.
Recommendation: Plan B.
- The competitor's 8% price cut makes ₹8 lakh EBIT uncertain, so the downside case is not hypothetical.
- Plan C's interest cover at ₹8 lakh is 8 ÷ 3.6 = 2.2; at ₹4 lakh it is 1.1, leaving almost nothing for fixed charges. One bad year could cause default.
- Plan B keeps EPS above Plan A in both scenarios, and its interest cover at ₹4 lakh is 1.67 - thin but manageable.
- Control: the family needs ₹12 lakh to hold 60% of Plan B's ₹20 lakh equity, but only ₹6 lakh for 60% of Plan C's ₹10 lakh equity. Plan C is cheaper for control, yet control is not worth insolvency risk.
Use Plan C only if a long-term contract covers, say, 70% of output.
3. Explain why Plan C's higher EPS is not automatically better, using financial leverage and fixed charges.
Read the worked answer
Higher EPS is not the same as higher value. Plan C raises EPS by adding a fixed charge - ₹3.6 lakh of interest - that must be paid whether or not boxes sell. This is financial leverage: it magnifies EPS when EBIT is above the indifference point and magnifies losses below it.
At ₹4 lakh EBIT, Plan C's EPS falls to ₹0.28 from ₹3.08, a 91% fall, while Plan A's EPS falls only 50%. The risk is borne by equity shareholders, whose residual claim shrinks first; lenders may also impose covenants on further borrowing. Plan C also reduces the cash buffer for working capital, which matters when a price war squeezes margins.
A finance manager therefore compares EPS with interest coverage, debt-service coverage, cash-flow volatility and control, not EPS alone. Plan C is a fair-weather capital structure; Plan B accepts a lower expected EPS in exchange for a survivable downside.