Problems¶
Question
One-up Ltd. has an Equity Share Capital of Rs. 5,00,000, divided into shares of Rs. 100 each. The company aims to raise an additional Rs. 3,00,000 for an expansion-cum-modernisation scheme and is considering the following financing alternatives:
- By issuing Equity Shares only.
- By issuing Rs. 1,00,000 in Equity Shares and Rs. 2,00,000 through 10% Debentures.
- By issuing Debentures only at 10% per annum.
- By issuing Rs. 1,00,000 in Equity Shares and Rs. 2,00,000 in 8% Preference Shares.
The estimated earnings before interest and taxes (EBIT) after expansion are projected to be Rs. 1,50,000, with a corporate tax rate of 35%. You are required to suggest the best alternative, providing your comments and analysis.
Solution¶
To determine the best financing alternative for One-up Ltd., we need to evaluate the impact of each option on the company's earnings per share (EPS). The following table illustrates the financial breakdown for each plan:
| Particulars | Plan I | Plan II | Plan III | Plan IV |
|---|---|---|---|---|
| Existing Equity Shares of Rs. 100 each | 5,00,000 | 5,00,000 | 5,00,000 | 5,00,000 |
| New Equity Shares of Rs. 100 each | 3,00,000 | 1,00,000 | - | 1,00,000 |
| 8% Preference shares | - | - | - | 2,00,000 |
| 10% Debentures | - | 2,00,000 | 3,00,000 | - |
| Capital Structure | 8,00,000 | 8,00,000 | 8,00,000 | 8,00,000 |
| Earnings before Interest & Taxes (EBIT) | 1,50,000 | 1,50,000 | 1,50,000 | 1,50,000 |
| Less: Interest on Debenture | - | 20,000 | 30,000 | - |
| Earning before tax (EBT) | 1,50,000 | 1,30,000 | 1,20,000 | 1,50,000 |
| Less: Income tax @ 35% | 52,500 | 45,500 | 42,000 | 52,500 |
| Earning after tax (EAT) | 97,500 | 84,500 | 78,000 | 97,500 |
| Less: Preference dividend @ 8% | - | - | - | 16,000 |
| Earning available to Equity Shareholders | 97,500 | 84,500 | 78,000 | 81,500 |
| Number of Equity Shares | 8,000 | 6,000 | 5,000 | 6,000 |
| Earnings per share (EPS) | Rs. 12.19 | Rs. 14.08 | Rs. 15.60 | Rs. 13.58 |
Conclusion¶
Based on the EPS for each plan, Plan III appears to be the most advantageous for the shareholders, with the highest EPS of Rs. 15.60. This plan involves funding the expansion entirely through debentures, which, despite increasing the interest burden, does not dilute the equity shareholding and results in a higher EPS. However, this plan also increases the financial risk due to the fixed interest obligation. The company's management should also consider the impact of increased debt on the company's leverage and risk profile before making a final decision.
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