Capital structure decisions:

EBIT EPS Analysis

1.ABC company has currently an all equity capital structure consisting of 15,000 equity shares of
Rs.100 each. The mgt is planning to raise another Rs.25 lakhs to finance a major programme of
expansion and is considering three alternative methods of financing.
i)
ii)
iii)

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 companys expected earnings before interest and taxes will be Rs.8 lakhs. Assuming a
corporate tax rate of 50%, determinethe EPD in each alternative and comment which alternative
is best and why?
2. A Ltd.Co. has equity share capital of Rs.5,00,000 divided into shares of Rs.100 each. It
wishes to raise furthe Rs.3,00,000 for expansion cum modernisation plans. The company plans
the following financing schemes:
a) All common stock
b) Rs.1,00,000 in common stock and Rs.2,00,000 in debt@ 10% p.a
c) All debts at 10% p.a
d) Rs.1,00,000 in common stock and Rs. 2,00,000 in preference capital with the rate of dividend
at 8%.
The companys existing earnings before interest and tax (EBIT) are Rs.1,50,000. The corporate
rate of tax is 50%. Determine the EPS in each plan and comment on the implications of Financial
leverage.
3. AB Ltd, needsRs.10,00,000 for expansion. The expansion is expected to yield an annual EBIT
of Rs.1,60,000. In choosing a financial plan, AB ltd. Has an objective of maximising earnings
per share. It is considering the possibility of issuing equity shares and raising debt of Rs.
1,00,000 or Rs.4,00,000 or Rs.6,00,000. The current MPS is Rs.25 and is expected to drop to
Rs.20 if the funds are borrowed in excess of Rs. 5,00,000.
Funds can be borrowed at the rates indicated below.
a) Upto Rs.1,00,000 at 8%
b) Over Rs.1,00,000 upto Rs. 5,00,000 at 12%
c) Over Rs.5,00,000 at 18%

Assume a tax rate of 50%. Determine the EPS for the three financing alternatives and suggest
the schemewhich would meet the objective of the management.
4. A companys capital structure consists of the following:
Equity share of Rs.100 each Rs.20 lakhs
Retained earnings
Rs.10 lakhs
9% Preference shares
Rs.12 lakhs
7% Debentures
Rs. 8 lakhs
Total
Rs.50 lakhs
The company earns 12% on its capital. Income tax rate is 50%.
The company requires a sum of Rs.25lakh to finance its expansion
programme for which the following alternatives are available.
i)
Issue of 20,000 equity shares at a premium of Rs.25 per share
ii)
Issue of 10% preference shares
iii)
Issue of 8% debentures.
iv)
It is estimated that the P/E ratios in the cases of equity,
preference and debenture financing would be 21.4,17 and 15.7
respectively.
5. XYZ ltd. Is considering three financial plans :
a) Total investment to be raised Rs.4,00,000.
b) Plans of financing proportion:
Plans

Equity

A
B
C

100%
50%
50%

Debt
50%
-

Preference
Shares
50%

c) Cost of debt 8%, preference shares 8%

d) Tax rate 50%
e) Equity shares of the face value of Rs.10 each will be issued at a
premium of Rs.10 per share.
f) Expected EBIT is Rs.1,60,000.
Determine for each plan:
i)

EPS ii) Financial break even point iii) EBIT range among the
plans for point of indifference.

Leverages:
1. From the following income statement for the year ended 31st March
2005, calculate and interpret its degree of operating leverage, degree
of financial leverage and degree of combined leverage.
Sales

10,50,00
0

Variable cost
7,67,000
Fixed cost
75,000
EBIT
2,08,000
Interest
1,10,000
Taxes (30%)
29,400
Net Income
6,86,00
2. A firm has sales of Rs.20,00,000, variable cost of Rs.14,00,000 and
fixed costs of Rs.4,00,000 and debt of Rs.10,00,000 @ 10% rate of
interest. What are the operating, financial and combined leverages? If
the firm wants to double its EBIT, how much of a rise in sales would be
needed on a percentage basis?
3. Calculate operating leverage and financial leverage under situations 1
and 2 and financial plans a and B respectively from the following
information. What are the combinations of operating and financial
leverage which give highest and least value?
Installed capacity
2,000 units
Annual Production and 50%
of
sales
installed
capacity
Selling price per unit
Rs.20
Variable cost per unit
Rs.10
Fixed costs
Situation 1
Rs.4,000
Situation 2
Rs.5,000
Capital structure:
Financial Plan
A (Rs)
B
(Rs)
Equity
5,000
15,000
Debt (cost 10%)
15,000
5,000

20,000
20,000
4. A firm has sales of Rs.75,00,000, variable cost of Rs.42,00,000 and
fixed cost of Rs 6,00,000. It has a debt of Rs.45,00,000 at 9% and
equity for Rs.55,00,000.
i)
What is the firms ROI?
ii)
Does it have a favourable financial leverage?
iii)
aor low asset leverage?
iv)
What are the operating, financial and combined leverages of the
firm?
v)
If the sales drop to Rs.50,00,000, what will be the new EBIT?
vi)
At what level the EBT of the firm will be equal to zero?