Page 109 - DMGT409Basic Financial Management

Basic Financial Management

Notes Solution:

Calculation of overall cost of capital
Equity Debt Weight Cost of Eq- Cost of Debt Overall cost of Capital (Ko = %)
Weight (W ) (Wd) uity (K ) (K ) K = [ K (W ) + K (W ) ] x 100
c
e
d
e
c
o
d
d
1.00 0.00 0.100 0.06 [(0.10 x 1.0) + (0.06 x 0.0)] x 100 = 10
0.90 0.10 0.100 0.06 [(0.10 x 0.90) + (0.06 x 0.10)] x 100 = 9.6
0.80 0.20 0.105 0.06 [(0.105 x 0.80) + (0.06 x 0.20)] x 100 = 9.68
0.70 0.30 0.110 0.065 [(0.11 x 0.70) + (0.065 x 0.30)] x 100 = 9.65
0.60 0.40 0.120 0.07 [(0.12 x 0.60) + (0.07 x 0.40)] x 100 = 10
Here optimal capital structure is one, with 90 per cent equity and 10 per cent debt since K is
less (9.6).
6.6.2 Approaches to Determine Appropriate Capital Structure

The following are the approaches to determine a firm’s capital structure: 1. EBIT - EPS Approach
2. Valuation Approach and 3. Cash fl ow Approach
1. EBIT - EPS Approach: This approach is helpful to analyse the impact of debt on earnings
per share.
2. Valuation Approach: This approach determines the impact of debt use on the shareholder
value.

3. Cash Flow Approach: This approach analyses the firm’s debt service capacity.

EBIT - EPS (Approach) Analysis

EBIT - EPS analysis try to understand how sensitive earnings per share (EPS) are to the changes

in earnings before interest and tax (EBIT) under different financial plans/capital structures/

alternatives. Use of fixed cost sources of finance in capital structure of a firm is known as

financial leverages / trading on equity. In other words, use of less cost source of fi nance to
maximise earnings per share (EPS), but the benefits are more when a firm uses debt as a source of

finance, due to cheap and interest is tax deductible source. Use of debt can be used to maximise

shareholder wealth only when a firm has a high level of operating profit (EBIT). EBIT - EPS

analyses is one way to study the relation between earnings per share (EPS) and various possible
levels of operating profit (EBIT), under various fi nancial plans.

Illustration 6: XYZ Co. Ltd. has a share capital of ` 1,00,000 face value of ` 10 each. It requires `
50,000 to finance expansion programme and is considering three alternative fi nancial plans.

(i) Issue of 5000 ordinary shares of ` 10 each
(ii) Issue of 500 preference shares of ` 100 each at 10 per cent and
(iii) Issue of 10 per cent debentures of ` 50,000
The company’s operating profi t (EBIT) after additional investment is ` 40,000 per annum. Tax
rate is 50 per cent. Show the effect of use of debt in fi nancial plan.

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