Page 141 - DMGT405_FINANCIAL%20MANAGEMENT

Unit 7: Capital Structure Decision

(b) It is extremely doubtful that investors would substitute personal leverage for Notes
corporate leverage, as they do not have the same risk characteristics. Rates of interests
are not the same for individuals and the firms.
2. The assumption that there is no corporate tax is unrealistic.

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Caution Existence of corporate tax results in higher value of the levered firm, since the
interest is tax deductible.
3. The assumption of no tries transaction cost is also imaginary. In reality, whenever a firm
tries to obtain debt capital associates creditors, they seek certain restrictions on the firm.
On the part of the firm, some protective comments incorporated in the loan contract.
4. In subsequently analyses, MM agreed that the leverage might increase the value of the
firm.

Task “As the debt-equity ratio increases, there is a trade-off between the interest tax shield
and bankruptcy, causing an optimum capital structure.” Do you agree with the statement?
Give reasons.

Self Assessment
Fill in the blanks:
10. The Net Income (NI) approach is the relationship between leverage and …………………and
value of the firm.
11. The ………………….. is the operational justification of MM hypothesis.
12. The Net Operating Income (NOI) approach is the opposite of the …………….approach.

7.5 Effects of a Financing Decision on Earnings Per Share

One of the present objectives of a finance function is to maximize both the return on ordinary
shares and the total wealth of the company. This objective is also important at the time of
deciding in the new source of finance. Earnings Per Share (EPS) denote what has been earned by
the company during a particular period in each of the ordinary shares. It can be worked out by
dividing net profit after interest, taxes and preference dividend, by the number of equity shares.
If the company has a number of options of new financing, it can compute the impact of each
method of new financing on earnings per share. It should also calculate the EPS without the new
financing and compares it with cash of the various alternatives of financing available, is accepted.
It is obvious that earnings per share would be the highest in case of financing, which has the least
cost to the company.

Example: X Ltd. requires 50 lacs for a new plant, which is expected to yield earnings
before interest and taxes of 10 lacs. The company has three alternatives for financing.
Option I: Raising debt of 5 lacs and the balance by equity.
Option II: Raising debt of 20 lacs and the balance by equity.
Option III: Raising debt of 30 lacs and the balance by equity.

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