A Company is considering two financial alternatives to Finance its expansion plan to ₹1.00 crore. First alternative: by issue of equity shares @ ₹12.50. Second alternative: by issue 14% debentures. Tax to be considered a

CS Professional · Financial, Treasury and Forex Management · PYQS · December 2021
A Company is considering two financial alternatives to Finance its expansion plan to ₹1.00 crore. First alternative: by issue of equity shares @ ₹12.50. Second alternative: by issue 14% debentures. Tax to be considered at 40%. Its present capital structure consists of equity shares of ₹20,00,000 (face value ₹10) and 8% debentures of ₹50,00,000. Expected price earning ratio in case of: first alternative is - 14 Second alternative is - 12. You are required to calculate the indifference point at which market price of share under both alternatives will be same.

Answer & Explanation:

The indifference point is the EBIT level where the Market Price Per Share (MPS) for both financing alternatives is equal. Current Capital Structure: Existing Equity Shares = ₹20,00,000 / ₹10 (face value) = 2,00,000 shares Existing Debentures = ₹50,00,000 @ 8% Existing Interest = 8% of ₹50,00,000 = ₹4,00,000 Expansion Plan: ₹1,00,00,000 Alternative I (Equity Financing): New Equity Shares = ₹1,00,00,000 / ₹12.50 = 8,00,000 shares Total Equity Shares (N1) = 2,00,000 + 8,00,000 = 10,00,000 shares Interest (I1) = Existing Interest = ₹4,00,000 P/E Ratio (P/E1) = 14 Alternative II (Debt Financing): New Debentures = ₹1,00,00,000 @ 14% Interest on New Debentures = 14% of ₹1,00,00,000 = ₹14,00,000 Total Interest (I2) = Existing Interest + New Interest = ₹4,00,000 + ₹14,00,000 = ₹18,00,000 Total Equity Shares (N2) = Existing Equity Shares = 2,00,000 shares P/E Ratio (P/E2) = 12 Tax Rate (t) = 40% or 0.40 Formula for MPS: MPS = EPS × P/E Ratio = [ (EBIT - Interest) × (1 - Tax Rate) / Number of Equity Shares ] × P/E Ratio Equating MPS for Alternative I and Alternative II: [ (EBIT - I1) × (1 - t) / N1 ] × P/E1 = [ (EBIT - I2) × (1 - t) / N2 ] × P/E2 [ (EBIT - 4,00,000) × (1 - 0.40) / 10,00,000 ] × 14 = [ (EBIT - 18,00,000) × (1 - 0.40) / 2,00,000 ] × 12 [ (EBIT - 4,00,000) × 0.60 / 10,00,000 ] × 14 = [ (EBIT - 18,00,000) × 0.60 / 2,00,000 ] × 12 Simplify by dividing (1 - 0.40) = 0.60 from both sides: [ (EBIT - 4,00,000) / 10,00,000 ] × 14 = [ (EBIT - 18,00,000) / 2,00,000 ] × 12 [ (EBIT - 4,00,000) × 14 ] / 10,00,000 = [ (EBIT - 18,00,000) × 12 ] / 2,00,000 Multiply both sides by 10,00,000: (EBIT - 4,00,000) × 14 = [ (EBIT - 18,00,000) × 12 ] × (10,00,000 / 2,00,000) (EBIT - 4,00,000) × 14 = (EBIT - 18,00,000) × 12 × 5 14 EBIT - 56,00,000 = (EBIT - 18,00,000) × 60 14 EBIT - 56,00,000 = 60 EBIT - 10,80,00,000 10,80,00,000 - 56,00,000 = 60 EBIT - 14 EBIT 10,24,00,000 = 46 EBIT EBIT = 10,24,00,000 / 46 EBIT = ₹22,26,086.96

Topics: Capital Structure and Valuation

Open in Interactive Practice Hub · Full Practice Hub · Chapter Weightage · More in this subject

Related Questions in this Topic