Page 110 - DMGT409Basic Financial Management

Unit 6: Capital Structure Theory

Solution: Notes

Calculation EPS
Financial Plan
Particulars I (Equity) II (Preference) III Debt - Equity
` ` `
EBIT 40,000 40,000 40,000
Less : Interest --- --- 5,000
EBT / or PBT 40,000 40,000 35,000
Less : Tax at 50% 20,000 20,000 17,500
PAT or EAT 20,000 20,000 17,500
Less: Preference dividend --- 5,000 ---
Earnings available to share holders. 20,000 15,000 17,500
No. of shares outstanding 15,000 10,000 10,000
Earnings available to shareholder
EPS = 1.333 1.5 1.75
No. of equity shares
Illustration 7: VS International Ltd., has a capital structure (all equity) comprising of ` 5,00,000

each share of ` 10. The firm wants to raise an additional ` 2,50,000 for expansion project. The

firm has the following four alternative financial plans I, II, III and IV. If The firm is able to earn

an operating profi t at ` 80,000 after additional investment and 50 per cent tax rate. Calculate EPS
for all four alternatives and select the preferable financial plan. Financial plans

I. Raise the entire amount in the form of equity capital.
II. Raise 50 per cent as equity capital and 50 per cent as 10 per cent debt capital.
III. Raise the entire amount as 12 per cent debentures.
IV. Raise 50 per cent equity capital and 50 per cent preference share capital at 10 per cent.

Solution
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
Less: Tax at 50% 80,000 67,500 50,000 80,000
40,000
40,000
25,000
33,750
EAT
Less: Preference dividend 40,000 33,750 25,000 40,000
Earnings available to share holders. --- --- 12500
No. of shares (equity) outstanding 40,000 33,750 25000 27500
EPS 75,000 62,500 50,000 62,500
0.53 0.54 0.50 0.44
As EPS is maximum as per plan-II, this is most-preferable fi nancial plan.
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 benefi ts of fi nancial

leverage begin to operate with respect to earnings per share (EPS). In other words, if the expected

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