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(^302) Financial Management
Plan C, an increase of 25 per cent in EBIT (from Rs.80,000 to Rs.1,00,000) results in a
100 per cent increase in EPS (from Re 1.3 to Rs.2.6), whereas the percentage increase
in EPS is only 40 per cent (from Rs.6.5 to Rs.9.1) as a result of the change in EBIT at
higher levels from Rs.1,60,000 to Rs.2,00,000 (i.e. 25 per cent increase).
Tables show that the EPS for different financing plans at a given level of EBIT is equal.
At EBIT levels above or below the given levels, the EPS is higher or lower. Thus, for
alternatives A and C at the EBIT level of Rs.1,20,000 the EPS is the same, that is, Rs.
3.9. If EBIT is below this level, alternative A (ordinary shares) will provide higher
EPS; above this level, the debt alternative (C) is better from the viewpoint of EPS.
The earnings per share (EPS) in alternatives A and B are the same at EBIT level of
Rs.1,00,000. Above this, B plan would lead to higher EPS; at levels lower than this,
financing plan A would provide higher EPS.
The debt alternative (B) gives higher EPS; at levels lower that this, financing plan A
would provide higher EPS.
Operating Conditions and Business Risk
One very important factor on which the variability of EPS depends is the growth and
stability of sales. As you may recall that EPS will fluctuate with fluctuations in sales.
The magnitude of the EPS variability with sales will depend on the degrees of operating
and financial leverages employed by the company. Firms with stable sales and favourable
cost price structure and successful operating strategy will have stable earnings and
cash flows and thus, can employ a high degree of leverage as they will not face difficulty
in meeting their fixed commitments The likely fluctuations in sales increase the business
risk. A small change in sales can lead to a dramatic change in the earnings of a company
when its fixed costs and debt are high. As a result, the shareholders perceive a high
degree of financial risk if debt is employed by such companies. A company will get into
a debt trap if operating conditions become unfavourable and if it lacks in focussed
strategy:
Exhibit DEBT TRAP: Case of Hindustan Shipyard
The fluctuating raw materials and component prices cause ups and downs in the revenues and
profits of a ship-building company. With the right operating strategy and appropriate prudent
financing, a company can manage to sail safely Hindustan Shipyard Limited (HSL), however,
is finding it quite difficult to come out of the troubled waters due to huge borrowings It has a
total outstanding of Rs 554 crore: working capital loan Rs 138 crore, development loan for
modernisation Rs 69 crore, and outstanding interest on these loans ns 160 crore; cash credit Rs
62 crore, outstanding interest, cash credit Rs 65 crore and penal interest Rs 60 crore. How did
this hppen?HSL's trouble began when, between 1981 and 1982, Japanese and South Korean
shipbuilders started offering "heavily subsidised rates" against the rates fixed by the Indian