- 2070 Chaitra · 1+6 marks
Capital structure; best option by EPS, three options
Short answer
Compute interest, EAT, and earnings for equity for each option, then divide by number of shares. Option (i) EPS = Rs 15.17, (ii) = Rs 12.91, (iii) = Rs 10.69. Option (i) is best.
Define capital structure. XYZ company has total capital of Rs 10,00,000 which consists of 40% share and 60% loan issued @ 12% interest. It requires Rs 20,00,000 more to invest in a project and is considering the following three options: (i) Rs 8,00,000 share and Rs 12,00,000 loan @ 14% interest; (ii) Rs 5,00,000 share, Rs 7,00,000 preference share @ 15% interest and Rs 8,00,000 loan @ 14% interest; and (iii) Rs 10,00,000 share and Rs 10,00,000 preference share @ 15% interest. Which is the best option based on Earning Per Share calculation if the earning before interest and tax in a year is Rs 5,00,000 and tax applicable is 30%?
Capital structure
Capital structure is the mix of long-term sources of funds (equity shares, preference shares, retained earnings and long-term debt) used by a firm to finance its total capital. Capital structure planning is the process of deciding the best proportion of these sources so that the cost of capital is lowest and the value of the firm and return to shareholders are highest.
Data and assumptions
- Existing capital Rs 10,00,000: share (40%) = Rs 4,00,000 and loan (60%) = Rs 6,00,000 at 12% (interest Rs 72,000).
- Face value of a share is taken as Rs 100. EBIT of Rs 5,00,000 is the same for all options; tax = 30%.
- All three options raise Rs 20,00,000 (the amounts add up in each case).
EPS for each option
Interest = 72,000 + interest on new loan. EAT = (EBIT - interest) x 0.70. Earnings for equity = EAT - preference dividend.
| Option | Shares | Interest | EBT | EAT | Pref. dividend | Earnings for equity | EPS (Rs) |
|---|---|---|---|---|---|---|---|
| (i) | 12,000 | 240,000 | 260,000 | 182,000 | 0 | 182,000 | 15.17 |
| (ii) | 9,000 | 184,000 | 316,000 | 221,200 | 105,000 | 116,200 | 12.91 |
| (iii) | 14,000 | 72,000 | 428,000 | 299,600 | 150,000 | 149,600 | 10.69 |
Working for option (i): shares = (4,00,000 + 8,00,000)/100 = 12,000; interest = 72,000 + 12,00,000 x 14% = 2,40,000; EBT = 2,60,000; EAT = 1,82,000; EPS = 1,82,000/12,000 = 15.17.
Answer: EPS is Rs 15.17 for (i), Rs 12.91 for (ii) and Rs 10.69 for (iii). Option (i) gives the highest EPS and is the best option.
✓ Answer checked by Claude Opus 5.5 (high effort)
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