Here we’ve cover 1 IMP question of a student in detail.
Thank you Arohi Shah for sharing the question, let’s look into the question.
We’ll focus on concept building where there’ll be no issue of whatever question comes around this concept.
The ROCE is 8%, the cost of debt is 10% then….
ROE is likely to be below 10% or ROE is likely to be above 10%.
Here we need to discuss ROCE, cost of debt and ROE formula.
Plus, how cost of debt works in context of EBIT (EBIT minus cost of debt = earnings before tax)
Earnings before tax minus tax will give you PAT.
For ROE we need PAT, for ROCE we need EBIT (here we’ll understand in detail)
Keep your pen & paper ready, write all these things and whatever related questions are there will cover them first.
Let’s discuss this question in detail:
ROCE: This ratio measures the profit generated for every rupee investing in the co. capital (debt & equity). An 8% ROC indicates the co. is making an 8% profit on its capital.
Here we’ll see combined capital (no matter if it is debt or equity) . Here our numerical will be EBIT.
Here we’ll see on each rupee how much profit co. is able to generate.
Here on every ₹1 co. is generating ₹8.
Next we’ll see cost of debt.
At what % co. is raising debt.
Cost of debt: This is the interest rate the co. pays on its’ borrowed money (debt). At 10%, the company’s borrowing is relatively expensive.
Here the earnings are lesser than debt by 2%.
It implies that the return generated by the co. capital employed is less than the cost of debt.
This suggests that the co. capital structure is not optimal, as the cost of debt exceeds the ROCE.
Here we’ll take 3 scenarios with combination of equity & debt.
The Return on Capital Employed is 8%, the cost of debt is 10%, return on equity is likely to be below 10%
1st is equity of ₹5L and debt of ₹3L with a total combined capital of ₹8L.
ROCE = 8% and by applying the formula of EBIT divide by total capital into 100 we need to calculate EBIT to find PAT
if we’re infusing equity of ₹5L.
EBIT divide by ₹8L into 100 is nothing but 8% of ₹8L = ₹64,000
Here we now vertically insert into an income statement starting with EBIT of ₹64,000, Debt interest of 10% on ₹3L, EBT (₹64,000 minus interest of ₹30,000 = ₹34,000)
Here 30% tax on ₹34,000 and PAT will be EBIT minus TAX
Here we need ROE with the formula given , after calculation we’re seeing our ROE is less than 10%.
Here the ROE is lesser than ROCE & interest on debt. So the cost of debt here is expensive.
The Return on Capital Employed is 8%, the cost of debt is 10%, return on equity is likely to be below 10%
In 2nd case, question is the same with equal value of debt & equity .
Need to prove that ROE is likely to be below 10%
IN the calculation given in the table gives you ROCE of ₹48,000
In the vertical statement, EBIT of ₹48,000, debt interest is 10% on ₹3L getting a EBT of ₹18,000 with a 30% tax and PAT of ₹12,600
Here we’ve taken low equity value, so maybe our ROE may be low.
In the ROE calculation table we got 4.3% which is still less than 10%
The Return on Capital Employed is 8%, the cost of debt is 10%, return on equity is likely to be below 10%
IN 3rd case, the equity is ₹5L and debt is ₹10L.
Here the EBIT will increase as the total capital infused has increased and we’ll see how much effect it’ll have on ROE.
After EBIT calculation we get it’s value = ₹1,20,000
IN the vertical statement we still see a debt interest of ₹1L remaining ₹20,000 EBIT and PAT of ₹14,000
Here again the ROE hampered as the cost of debt is too much (so ROE is less than 10%)
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