Untitled-29

Capital Structure Theories^321

Less taxes 13,125 15,750

Earnings after tax 24,375 29,250

Number of equity shares 5,000 7,000

Earnings per share 4.875 4.18

P/E ratio (times) 6 7

Market price of the share 29.25 29.25

ROI-ROE Analysis

In the preceding section we looked at the relationship between EBIT and EPS under

alternative financing plans. Pursuing a similar line of analysis, we may look at the

relationship between the return on investment (ROI) and the return on equity (ROE)

for different levels of financial leverage.

Exhibit 2: Probability Distributions of EBIT

Suppose a firm, Korex Limited, which requires an investment outlay of Rs 100 million,

is considering two capital structures:

Capital Structure A Capital Structure B

(Rs in million) (Rs in million)

Equity 100 Equity 50

Debt 0 Debt 50

While the average cost of debt is fixed at le~per cent, the ROI (defined as EBIT

divided by total assets) may vary widely. The tax rate of the firm is 50 per cent.

Based on the above information, the relationship between ROI and ROE (defined as

equity earnings divided by net worth) under the two capital structures, A and 8, would

be as shown in Exhibit graphically the relationship is shown in Exhibit

1.0 2.0 3.0 4.0 5.0 6.0 7.0

1.0

2.0

A

B

EBIT (Rs. in million)