- 2080 Baisakh · 5 marks
Best financing option; EBIT Rs 350,000
Short answer
Compute interest, EAT, and earnings for equity for each option. Option (i) EPS = Rs 20.13, option (ii) EPS = Rs 20.83. Option (ii) gives the higher EPS and is selected.
A project has a capital structure consisting of 4000 ordinary shares @ Rs 100 per share and loan capital of $600,000 @ 10% interest per year. It wants to raise additional capital of $1 million and has two options: (i) 4000 ordinary shares @ Rs 100 per share and loan capital of 6000,000 @ 10% interest per year; (ii) 2000 ordinary shares @ Rs 100 per share, Rs 300,000 preference share @ 12% dividend per year; and loan capital of 500,000 @ 12% interest per year. Select the best option if EBIT = Rs 350,000 and tax rate = 30%.
Data and assumptions
- Existing: 4,000 shares at Rs 100 (Rs 4,00,000) and loan Rs 6,00,000 at 10% (interest Rs 60,000).
- Additional capital is Rs 10,00,000 in both options (the printed "$" and "6000,000" are read as Rs and Rs 6,00,000). Option (i): 4,000 shares (Rs 4,00,000) + loan Rs 6,00,000 at 10%. Option (ii): 2,000 shares (Rs 2,00,000) + preference shares Rs 3,00,000 at 12% + loan Rs 5,00,000 at 12%.
- EBIT = Rs 3,50,000; tax = 30%. The option with the highest EPS is selected.
| Option | Shares | Interest | EBT | EAT | Pref. dividend | Earnings for equity | EPS (Rs) |
|---|---|---|---|---|---|---|---|
| (i) | 8,000 | 120,000 | 230,000 | 161,000 | 0 | 161,000 | 20.13 |
| (ii) | 6,000 | 120,000 | 230,000 | 161,000 | 36,000 | 125,000 | 20.83 |
Working for option (i): shares = 4,000 + 4,000 = 8,000; interest = 60,000 + 6,00,000 x 10% = 1,20,000; EAT = 2,30,000 x 0.70 = 1,61,000; EPS = 1,61,000/8,000 = 20.125.
Working for option (ii): shares = 4,000 + 2,000 = 6,000; interest = 60,000 + 5,00,000 x 12% = 1,20,000; EBT = 2,30,000; EAT = 2,30,000 x 0.70 = 1,61,000; preference dividend = 3,00,000 x 12% = 36,000; earnings for equity = 1,25,000; EPS = 1,25,000/6,000 = 20.83.
Answer: EPS (i) = Rs 20.13, EPS (ii) = Rs 20.83. Option (ii) gives the higher EPS and is selected. The difference is small; if the firm wants to avoid a fixed preference dividend or more financial risk, the choice can be reviewed, but on the EPS basis option (ii) is best.
✓ Answer checked by Claude Opus 5.5 (high effort)
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