Illustration 1: ABC company has currently an all-equity capital structure consisting of 15,000 equity shares of Rs. 100 each. The Management is planning to raise another Rs.25 lakhs to finance a major program of expansion and is considering three alternative methods of financing:
- to issue 25,000 equity shares of Rs.100 each.
- To issue 25,000, 8% debentures of Rs.100 each
- To issue 25,000, 8% preference shares of Rs.100 each.
The company’s expected earnings before interest and taxes will be Rs. 8 Lakhs. Assuming a corporate tax rate of 50 percent, determine the earning per share (EPS) in each alternative and comment on which alternative is best and why?
Solution:
Alternative I Equity Financing |
Alternative II Debt Financing |
Alternative III Preference Shares Financing |
|
Earnings before Interest and Tax (EBIT) |
8 |
8 |
8 |
Less Interest |
—- |
2 |
—– |
Earnings after Interest but before Tax (EBIT) |
8 |
6 |
8 |
Less Tax @50% |
4 |
3 |
4 |
Earnings after tax |
4 |
3 |
4 |
Less Preference Dividend |
2 |
||
Earnings Available to Equity Shareholders |
4 |
3 |
2 |
Number of Equity Shares |
40,000 |
15,000 |
15,000 |
4,00,000 |
3,00,000 |
2,00,000 |
|
Earning per share (EPS) |
40,000 |
15,000 |
15,000 |
Rs.10 |
Rs.20 |
Rs.13.33 |
Comments. As the earnings per share are highest in alternative II, i.e., debt financing, the company should issue 25,000 8% debentures of Rs. 100 each. It’ll double the earnings of the equity shareholders without the loss of any control over the company.