Capital structure problems 2

Financial Management - Capital Structure Solved Problems II

1. FINANCIAL MANAGEMENT CAPITAL STRUCTURE By: Smt.UMA MINAJIGI REUR HEAD, DEPT. OF COMMERCE & Management Smt. V G Degree College for Women, Kalaburagi Solved Problems -2

2. Meaning: Capital structure is defined as the combination of equity and debt that is put into use by a company in order to finance the overall operations of the company and for its growth. Capital Structure is a mixture of the capital put in to the business. CAPITAL STRUCTURE

3. According to E.W. Walker, “ an Optimum Capital Structure can be properly defined as, that security mix that minimises the firm’s cost of cpital and maximise the firm’s value. Equity capital and retained earnings are called Equity. Payment of dividend is not fixed, depends on profit. Borrowed Fund is Debt. It is fixed liability of the company which has to pay the fixed rate of interest, whether company makes profit or loss. OPTIMUM CAPITAL STRUCTURE

4. There are four fundamental or basic patterns of capital structure for a company. They are: Only Equity Shares Equity Shares and Preference Shares Equity Share and Long term borrowings like debentures and long term loans. Equity Shares and Preference Shares and Long term borrowings like debentures and long term loans. BASIC PATTERNS OF CAPITAL STRUCTURE

5. 3. A company has a Equity share capital of Rs.10,00,000 divided into shares of Rs.100 each. The management is planning to raise another Rs.6,00,000 for expansion through one of  the following alternatives : All common stock (i.e, equity shares). Rs.3,00,000 in common stock and Rs.3,00,000 in debts at 10%. All debts at 10% p.a. Rs.2,00,000 in common stock and Rs.4,00,000 in preference share capital with rate of dividend at 8%. The company’s present earnings before interest and tax (EBIT) is Rs.3,00,000, per annum tax 50%.Determine the earnings per share (EPS) in each plan and comment on the implications of financial leverage. PROBLEMS ON CAPITAL STRUCTURE

6. Solution: Particulars Present Capital Structure Expansion Plan Plan I Plan II Plan III Plan IV Operating Profit (EBIT) 3,00,000 3,00,000 3,00,000 3,00,000 3,00,000 Less: Interest -- -- 30,000 60,000 -- Profit before tax (PBT) 3,00,000 3,00,000 2,70,000 2,40,000 3,00,000 Less: Tax 1,50,000 1,50,000 1,35,000 1,20,000 1,50,000 Profit after tax (PAT) 1,50,000 1,50,000 1,35,000 1,20,000 1,50,000 Less: Dividend on Preference Share -- -- -- -- 32,000 Profit available for equity shareholders 1,50,000 1,50,000 1,35,000 1,20,000 1,18,000 No. Of Equity Shares 10,000 Shares 16,000   Shares 13,000   Shares 10,000   Shares 12,000 Shares EPS = Amount for Equity Shares                     No. Of shares 1,50,000/10,000 Rs.15 1,50,000/16,000 = Rs.9.375 1,35,000/13,000 = Rs10.38 1,20,000/10,000 = Rs.12 1,18,000/12,000 = Rs.9.83 Dilution against present EPS Rs. 15 --- ( 9.375 -15) = -5.625 (10.38-15) = -4.62 (12-15) = -3 (9.83-15) = -5.17

7. EBIT-EPS Analysis EBIT-EPS is a yard stick to evaluate the firm's performance for the investors. It is an important tool for designing the optimum Capital Structure. Which provides the highest EPS. EBIT-EPS analysis is widely used by finance measuring the impact of use of debt capital.

8. 4. Anu company is considering three different plans of finance. Its total cost is Rs.80,00,000. These are: PROBLEMS ON CAPITAL STRUCTURE Plan A Plan B Plan C Equity Shares of Rs.100 each 40,00,000 34,00,000 20,00,000 Debt 10% Debentures 40,00,000 46,00,000 60,00,000 80,00,000 80,00,000 80,00,000 Sales for the first three years of operations are estimated at Rs. 80,00,000, Rs.120,00,000 and Rs.150,00,000. A profit of 12% before interest and taxes is forecast to be achieved. Tax @50%. Compute earnings per share in each of the following alternative plans of financing for three years.

9. Solution: Particulars Proposals Plan A Plan B Plan C Operating Profit (EBIT) 12% of 80,00,000 9,60,000 9,60,000 9,60,000 Less: Interest on Debt 10% 4,00,000 4,60,000 6,00,000 Profit before tax (PBT) 5,60,000 5,00,000 3,60,000 Less: Tax 2,80,000 2,50,000 1,80,000 Profit after tax (PAT) 2,80,000 2,50,000 1,80,000 Less: Dividend on Preference Share -- -- -- Profit available for equity shareholders 2,80,000 2,50,000 1,80,000 No. Of Equity Shares 40,000   Shares 34,000   Shares 20,000   Shares EPS = Amount for Equity Shares                     No. Of shares 2,80,000/40,000 = Rs.7 2,50,000/34,000 = Rs.7.55 1,80,000/20,000 = Rs.9 Computation of EPS First Year

10. Solution: Particulars Proposals Plan A Plan B Plan C Operating Profit (EBIT) 12% of 120,00,000 14,40,000 14,40,000 14,40,000 Less: Interest on Debt 10% 4,00,000 4,60,000 6,00,000 Profit before tax (PBT) 10,40,000 9,80,000 8,40,000 Less: Tax 5,20,000 4,90,000 4,20,000 Profit after tax (PAT) 5,20,000 4,90,000 4,20,000 Less: Dividend on Preference Share -- -- -- Profit available for equity shareholders 5,20,000 4,90,000 4,20,000 No. Of Equity Shares 40,000   Shares 34,000   Shares 20,000   Shares EPS = Amount for Equity Shares                     No. Of shares 5,20,000/40,000 = Rs.13 4,90,000/34,000 = Rs.14.41 4,20,000/20,000 = Rs.21 Computation of EPS Second Year

11. Solution: Particulars Proposals Plan A Plan B Plan C Operating Profit (EBIT) 12% of 150,00,000 18,00,000 18,00,000 18,00,000 Less: Interest on Debt 10% 4,00,000 4,60,000 6,00,000 Profit before tax (PBT) 14,00,000 13,40,000 12,00,000 Less: Tax 7,00,000 6,70,000 6,00,000 Profit after tax (PAT) 7,00,000 6,70,000 6,00,000 Less: Dividend on Preference Share -- -- -- Profit available for equity shareholders 7,00,000 6,70,000 6,00,000 No. Of Equity Shares 40,000   Shares 34,000   Shares 20,000   Shares EPS = Amount for Equity Shares                     No. Of shares 7,00,000/40,000 = Rs.17.50 6,70,000/34,000= Rs.19.70 6,00,000/20,000 = Rs.30 Computation of EPS Third Year

12. 5. A Company needs Rs.24,00,000 for the installation of new factory which would yield an annual EBIT of Rs.4,00,000. The company has objective of maximising the earnings per share. It is considereing the possibility of insuring equity shares plus raising a debt of Rs.4,00,000, Rs.12,00,000 and Rs. 20,00,000. The current market price per share is Rs.40 which is expected to drop to Rs.25 per share, if the borrowings were exceed Rs.15,00,000. Cost of borrowings are indicated as under: Upto Rs.5,00,000   10% Between Rs.5,00,001 and Rs.12,50,000   14% Between Rs.12,50,001 and Rs.20,00,000   16% Assuming Tax rate as 50%. Workout the EPS and scheme which would meet the objective of management.

13. Solution: Particulars Proposals I II III Total amount required 24,00,000 24,00,000 24,00,000 Less: Debt amount 4,00,000 12,00,000 20,00,000 Equity Amount 20,00,000 12,00,000 4,00,000 No. of Shares = Equity Amount Market price of shares 20,00,000/40 = 50,000 Shares 12,00,000/40 =30,000 Shares 4,00,000/ 25 = 16,000 Shares Calculation of Equity Shares The current market price per share is Rs.40 which is expected to drop to Rs.25 per share , if the borrowings were exceed Rs.15,00,000.

14. Solution: Particulars Proposals I II III Total amount required 24,00,000 24,00,000 24,00,000 Less: Debt amount 4,00,000 12,00,000 20,00,000 Calculation of Interest on Debt I :: 4,00,000 * 10/100 = 40,000 Interest II :: 12,00,000 *:-- Upto 5,00,000 *10/100 = 50,000 Balance 7,00,000 * 14/100 = 98,000 1,48,000 III :: 20,00,000 *:- Upto 5,00,000 *10/100 = 50,000 Next (12,50,000-5,00,000) 7,50,000 * 14/100 =1,05,000 Balance (20,00,000-5,00,000-7,50,000) 7,50,000 * 16/100 = 1,20,000 50,000+1,05,000+1,20,000 = 2,75,000 Calculation of Equity Shares Upto Rs.5,00,000   10% Between Rs.5,00,001 and Rs.12,50,000   14% Between Rs.12,50,001 and Rs.20,00,000   16%

15. Solution: Particulars Proposals I II III Operating Profit (EBIT) 4,00,000 4,00,000 4,00,000 Less: Interest on Debt 10% 40,000 1,48,000 2,75,000 Profit before tax (PBT) 3,60,000 2,52,000 1,25,000 Less: Tax 1,80,000 1,26,000 62,500 Profit after tax (PAT) 1,80,000 1,26,000 62,500 Less: Dividend on Preference Share -- -- -- Profit available for equity shareholders 1,80,000 1,26,000 62,500 No. Of Equity Shares 50,000   Shares 30,000   Shares 16,000   Shares EPS = Amount for Equity Shares                     No. Of shares 1,80,000/50,000 = Rs.3.60 1,26,000/30,000= Rs.4.2 62,500/16,000 = Rs.3.91 Computation of EPS Proposal II is accepted as its EPS is highest.

16. Thank you