Question

A project under consideration by your company requires a capital investment of
Rs. 60 lakhs. Interest on term loan is 10% p.a. and tax rate is 50% Calculate the
point of indifference for the project, if the debt-equity ratio insisted by the
financing agencies is 2:1:
O 6 lakhs
O 8 lakhs
O 5 lakhs
O 2 lakhs​

Answer 1

Step-by-step explanation:

2 lakh

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Answer 2

The point of indifference is 6 lakhs

Therefore, option (1) is correct.

Step-by-step explanation:

We know that if X is Point of Indifference, $I_1$ is interest under the first alternative financial plan and $I_2$ is interest under the second alternative financial plan then

$\boxed{\frac{(X-I_1)(1-T)-PD}{N_1}=\frac{(X-I_2)(1-T)-PD}{N_2}}$

Where,

T is tax rate

PD is preferred dividend

$N_1$ is amount of equity share capital under alternative 1

$N_2$ is amount of equity share capital under alternative 2

According to the question, there are two viable options

Option 1: Raise the entire amount of 60 lakhs by equity shares, in which case there will be no debt

Option 2: Raise the amount of 40 lakhs by debt and remaining 20 lakhs through equity shares keeping the debt to equity ratio as 2 : 1

Here the preferred dividend PD = 0

Thus,

$I_1=0$ as there will be no interest in the case of option 1

$I_2=10% \text{of} 40=4$

$T=50%=0.5$

$N_1=60$

$N_2=20$

Thus,

$\frac{(X-0)(1-0.5)-0}{60}=\frac{(X-4)(1-0.5)-0}{20}$

$\implies \frac{X}{3}=X-4$

$\implies X=3X-12$

$\implies 2X=12$

$\implies X=6$

Therefore, the point of indifference of the project is 6 lakhs

Hope this answer is helpful.

Know More:

Q: What is the indifference point? Why is it so called? What is its usefulness?

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