Page 204 - DMGT207_MANAGEMENT_OF_FINANCES

Unit 8: Capital Structure Decision

Solution: Notes
Calculation of EPS
Financial Plan
Particulars
I II III IV
EBIT 80,000 80,000 80,000 80,000
Less: Interest --- 12,500 30,000 ---
EBT 80,000 67,500 50,000 80,000
Less: Tax at 50% 40,000 33,750 25,000 40,000
EAT 40,000 33,750 25,000 40,000
Less: Preference dividend --- --- 12500
Earnings available to share holders. 40,000 33,750 25000 27500
No. of shares (equity) outstanding 75,000 62,500 50,000 62,500
EPS 0.53 0.54 0.50 0.44
As EPS is maximum as per plan-II, this is most-preferable financial plan.

8.11.2 Indifference Point

The break-even EBIT level of indifference point, is when the EPS is same for two alternative
capital structures. It may be defined as the level of EBIT beyond which the benefits of financial
leverage begin to operate with respect to Earnings Per Share (EPS). In other words, if the expected
level of EBIT is less than the indifference point, it is advantageous with the use of equity capital
to maximise EPS.
Indifference point between two capital structures can be obtained by using the following formula:
x – I 1  (1– t) – PD (1 Dt)  (x – I )(1– t)– PD(1  Dt)

2
ES 1 ES 2
Where
X = EBIT I I = Interest under alternatives 1 and 2
1 2
t = Tax rate PD = Preference dividend
Dt = Preference dividend tax
ES , ES = No. of equity share outstanding under alternative 1 and 2
1 2
Illustration 8: WDC Ltd., has a total capitalisation of 10 lakh consisting entirely of equity
capital ( 10 each share). It is planning to raise an additional funds of 5 lakh for implementing
capital budgeting project. There are two alternatives available to the company.

1. Entire equity share capital by issue of shares.
2. Entire amount by debt at 10 per cent interest.
The company is in the tax brackets of 50 per cent. Calculate indifference point.

Solution:
Indifference point formula
(x – I) (1– 0.5) (x – 1) (1– 0.5)
= =
ES ES
1 2
x (1– 0.5) (x – 50,000) (1– 0.5)
= =
(1,00,000  50000) 1,00,000

= 50,000x = 75,000x – 3,75,00,00,000

LOVELY PROFESSIONAL UNIVERSITY 199