CF Assignment 1 and 2

A company is considering raising Rs 2,00,000 to finance modernisation of its plant.

The following three financing alternatives are feasible:
i) the company may issue 20000 shares at Rs10 per share ,
ii) the company may issue 10000 shares at Rs 10 per share and 1000 debentures of
Rs 100 denomination bearing a 14 percent rate of interest .iii) the company may
issue 5000 shares at Rs 10 per share and 1500 debentures of Rs 100
denominations bearing a 14 percent rate of interest. If the company's profits before
interest are:
a)Rs 5000, b) Rs 12000, c) Rs 25000, what are the respective earnings, Rate of
return on total capital and rates of return on total capital and rates of return on total
equity capital , for each of three alternatives ? Which alternative would you
recommend and why? If the corporate taxes are 35 percent, what are your answers
to the above questions? How do you explain the difference in your answers?

EPS Formula
EPS = (EBIT-I)(1-T) - (P.D)
N

Alternatives 1 2 3
20000*10=200000 10000*10=100000 5000*10=50000
EBIT levels 1000*100=100000 1500*100=150000

Rs.5000
Without tax Rs.0.25 Rs. -0.8182 Rs. -2.4615
With 35% tax Rs.0.1625 Rs. -0.5318 Rs. -1.6

Rs.12000
Without tax Rs.0.60 Rs. -0.1818 Rs. -1.3846
With 35% tax Rs.0.39 Rs. -0.1182 Rs. -0.9

Rs.25000
Without tax Rs.1.25 Rs. 1 Rs.0.6154
With 35% tax Rs.0.8125 Rs.0.5318 Rs.0.4

The EPS values for the alternatives for each EBIT level are as thus.

With tax, The EPS value is found to decrease across the continuum.

The EPS value is highest for all alternatives in EBIT of Rs.25000 as profits before interest are more
than debt interest in each alternative. Alternative recommended is alternative 1.
Return on total capital is: (Net income - Dividends) / (Debt + Equity)
Net income = EBIT, Dividends = 0, Debt and equity exist for each alternative.

Alternatives 1 2 3
20000*10=200000 10000*10=100000 5000*10=50000
EBIT levels 1000*100=100000 1500*100=150000

Rs.5000 5000/(200000+0) 5000/(100000+100000) 5000/(50000+150000)

0.025 or 2.5% 0.025 or 2.5% 0.025 or 2.5%

Rs.12000 12000/(200000+0) 12000/(100000+100000) 12000/(50000+150000)

0.06 or 6% 0.06 or 6% 0.06 or 6%

Rs.25000 25000/(200000+0) 25000/(100000+100000) 25000/(50000+150000)

0.125 or 12.5% 0.125 or 12.5% 0.125 or 12.5%

Return on total equity capital is: (Net income - Dividends) / (Equity)

Net income = EBIT, Dividends = 0, Debt and equity exist for each alternative.

Alternatives 1 2 3
20000*10=200000 10000*10=100000 5000*10=50000
EBIT levels 1000*100=100000 1500*100=150000

Rs.5000 5000/(200000+0) 5000/(100000) 5000/(50000)

0.025 or 2.5% 0.05 or 5% 0.1 or 10%

Rs.12000 12000/(200000+0) 12000/(100000) 12000/(50000)

0.06 or 6% 0.12 or 12% 0.24 or 24%

Rs.25000 25000/(200000+0) 25000/(100000) 25000/(50000)

0.125 or 12.5% 0.25 or 25% 0.5 or 50%

The return on total capital in each EBIT level is same in all 3 alternatives in each level.

The return on total equity capital is highest in alternative 3 as debt amounts are highest in
alternative 3 in each EBIT level.