A company has a share capital of Rs. 10,00,000 divided into equity shares of Rs. 10. It has a major expansion programme requiring an additional investment of Rs. 5,00,000. Financial Manager is considering the following alternatives for raising this amount: i. Issue of 50,000 Equity shares at par ii. Issue of 50,000, 12% Preference Shares of Rs. 10 each iii. Issue of 10% debentures of Rs. 5,00,000. The company present earnings before interest and tax Rs. 4,00,000 p.a. You are requested to calculate the effect of each of the above mode of financing on EPS and suggest the best alternative, if EBIT continues to be Rs. 4,00,000 after expansion
Answers
Explanation:
It is true that capital structure cannot affect the total earnings of a firm but it can affect the share of earnings available for equity shareholders. Say, for example, a company has an Equity Capital of 1000 shares of Rs. 100 each fully paid and earns an average profit of Rs. 30,000. Now the company wants to make an expansion and needs another Rs. 1,00,000.
The options with the company are-either to issue new shares or raise loans @ 10% p.a. Assuming that the company would earn the same rate of profits. It is advisable to raise loans as by doing so earnings per share will magnify. The company shall pay only Rs. 10,000 as interest and profit expected shall be Rs. 60,000 (before payment of interest).
After the payment of interest the profits left for equity shareholders shall be Rs. 50,000 (ignoring tax). It is 50% return on the equity capital against 30% return otherwise. However, leverage can operate adversely also if the rate the interest on long-terms loans is more than the expected rate of earnings of the firm.
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