Case Study

A Company has an existing capital structure of equity shares at Rs.

100 each of Rs. 6,000,000/- 12% Preference Shares at Rs.
3,000,000/- and 15% Debentures at Rs 11,000,000. The expansion
plan has a project cost of Rs. 5,000,000/- for which the company
can collect a debt at 18% and issue Preference Shares at 15% due
to the recessionary conditions. The expected EBIT is of Rs.
3,000,000/-. Suggest different combinations to be considered by
the company for financing the project cost. The combination can be
financed with maximum of two sources included in the capital
structure. The management has asked to consider a ratio of equity
and preference shares at 1:1 while the debt to equity ratio in
combinations of 1:1 and 3:2. The objective of the company is to
maximize the EPS.

Preface

T
he main objective of any firm on the verge of financing its capital needs either
during the initial formation phase or during the operation phase should be to
obtain an optimum capital structure. To quote Ezra “optimum leverage is that
mix of debt and equity which will maximize the market value of the company’s share
and minimize the overall cost of capital.”Hence a capital structure should be framed
with an objective of maximizing the interest of the ordinary shareholders, maximizing
the EPS of the company.

“However there is no tailor made capital structure for all the business enterprise.”

A company’s capital structure is a function of the nature of its business and the
degree of risk faced by the particular business over a period of time. Therefore prior
to making any financing decisions, beside over viewing the general theory of
finance, the circumstance of the business enterprise in question has to be evaluated.

Moreover when the funds are being raised in the recessionary phase, whilst the
capital market is plagued by scarcity of loanable funds and high rate of interest,
every decision have to be taken shrewdly. This is so because making an investment
in recessionary period through mortgage of assets is quite risky as the economic
environment is unpredictable. Also in bearish conditions as investors often prefer to
play safe so as to avoid making capital loss, interest rates are pretty high.

Similarly prior to making any investment promises the return on capital employed
should also be judiciously evaluated. The return on investment should be higher than
the cost of capital as not achieving this will lower the wealth of the shareholder and
concurrently reduces the EPS. Techniques like NPV and IRR help to better judge the
investment alternatives.

Henceforth every aspect has to be evaluated clearly before taking decision regarding the
selection of the appropriate mix for financing the project cost.

The following are the financing mix considered by the firm in prospect.

Plan A : Equity share and Preference share at the ratio of 1:1

Plan B : Equity share and Debenture at the ratio of 1:1
Plan C : Equity share and Debenture at the ratio of 3:2
Plan D: All Equity Share
Plan E: All Preference Share
Plan D: All Debt or Debenture

Statement showing calculation of EPS

 Plan A Plan B Plan C Plan D Plan E Plan E
Existing Capital
Structure
Equity share at Rs 60,00,00 60,00,00 60,00,00 60,00,00
100 each 0 60,00,000 0 60,00,000 0 0
12% Preference 30,00,00 30,00,00 30,00,00 30,00,00
Share 0 30,00,000 0 30,00,000 0 0
1,10,00,0 1,10,00,0 1,10,00,0 1,10,00,0 1,10,00,0 1,10,00,0
15% Debenture 00 00 00 00 00 00
2,00,00, 2,00,00,0 2,00,00, 2,00,00,0 2,00,00, 2,00,00,
Total 000 00 000 00 000 000

Post Expansion
structure
Equity share at Rs 85,00,00 80,00,00 1,10,00,0 60,00,00 60,00,00
100 each 0 85,00,000 0 00 0 0
12% Preference 30,00,00 30,00,00 30,00,00 30,00,00
share 0 30,00,000 0 30,00,000 0 0
15% Preference 25,00,00 50,00,00
share 0 - - - 0 -
1,10,00,0 1,10,00,0 1,10,00,0 1,10,00,0 1,10,00,0 1,10,00,0
15% Debenture 00 00 00 00 00 00
30,00,00 50,00,00
18% Debenture - 25,00,000 0 - - 0
2,50,00, 2,50,00,0 2,50,00, 2,50,00,0 2,50,00, 2,50,00,
Total 000 00 000 00 000 000

30,00,0 30,00,00 30,00,0 30,00,00 30,00,0 30,00,0

E.B.I.T 00 0 00 0 00 00
Less: Interest
16,50,00 16,50,00 16,50,00 16,50,00
15% Debenture 0 16,50,000 0 16,50,000 0 0
18% Debenture - 4,50,000 5,40,000 - - 9,00,000
13,50,00 13,50,00
E.B.T 0 9,00,000 8,10,000 13,50,000 0 4,50,000
Less: Taxation (50%) 6,75,000 4,50,000 4,05,000 6,75,000 6,75,000 2,25,000
P.B.T 6,75,000 4,50,000 4,05,000 6,75,000 6,75,000 2,25,000
Less: Preference
Dividend
12% Preference
Share 3,60,000 3,60,000 3,60,000 3,60,000 3,60,000 3,60,000
15% Preference
Share 3,75,000 - - - 7,50,000 -
Net Earnings -60,000 90,000 45,000 3,15,000 -4,35,000 -1,35,000

Equity Shares 85,000 85,000 80,000 1,10,000 60,000 60,000

E.P.S ( Earning Per

Share) -0.7058 1.058 0.562 2.86 -7.25 -2.25
Analysis
The analysis of EPS of all the possible alternatives leads to the conclusion that
the 4th alternative or Plan D is the most optimal choice. With the EPS of 2.86, the
option of issuing only equity share scores over other financing options.

Plan A, Plan E and Plan F show negative EPS at (-0.7058), (-7.25) and (-2.25)
respectively, owing to the adverse net earnings. Hence these alternatives cannot
be considered by the management for financing the project cost as this will not
lead to maximization of EPS.

Similarly though Plan B and Plan C have positive EPS, the management should
opt for Plan E as it yields a maximum EPS.