FIN2101 BUSINESS FINANCE II
MODULE 7 - CAPITAL STRUCTURE
QUESTION 1
The Uthinko Company Ltd is comparing two different capital structures,an all-equity plan (Plan 1) and a levered plan (Plan 2),Under Plan 1,Uthinko would have 20 000 shares outstanding,Under Plan 2,Uthinko would have 10 000 shares and $50 000 in debt outstanding,The interest rate is 12% and the tax rate is 30%.
a) If EBIT is $10 000,which plan will result in the higher EPS?
b) If EBIT is $20 000,which plan will result in the higher EPS?
c) What is the breakeven EBIT,ie the indifference point for the 2 plans?
QUESTION 2
Lynch-Lyons Ltd has decided to finance a $4 million expansion program by issuing either ordinary shares or debentures,Currently the firm has 200 000 ordinary shares outstanding and no long-term debt,Ordinary shares can be sold to net $40 per share,The debenture issue will be a 25-year issue at 12% interest,The tax rate is 30%.
a) Assuming that the program will give rise to earnings before interest and taxes (EBIT) of $1.5 million,calculate the expected earnings per share (EPS) for the two (2) alternative financing plans.
b) Construct a simple EBIT-EPS graph which would indicate which of the financing plans should be preferred.
c) Calculate mathematically the breakeven level of EBIT,ie the indifference point for the two plans.
d) Comment on your graph in b) above and your answer to c) above.
QUESTION 3
Hi Grade Regulator Ltd has currently 3 million ordinary shares outstanding with a market price of $2 per share,It also has $2 million in 6% debentures,The company is considering a $3 million expansion program that it can finance in one (1) of four (4) ways:
Plan 1 All ordinary shares at $2 per share
Plan 2 Debentures at 8% interest
Plan 3 Preference shares at 7%
Plan 4 Half ordinary shares at $2 per share and half 8% debentures
a) For a hypothetical level of EBIT of $1 million,calculate the earnings per share (EPS) for each of the alternative methods of financing,Assume a tax rate of 30%.
b) Calculate the indifference points between:
- Plans 1 and 2
- Plans 1 and 4
- Plans 2 and 4.
c) Interpret your answers in b) above.
FIN2101 BUSINESS FINANCE II
SOLUTIONS TO TUTORIAL QUESTIONS
MODULE 7 - CAPITAL STRUCTURE
QUESTION 1
a)
Plan 1
Plan 2
Earnings Before Interest &Tax (EBIT)
$10 000
$10 000
Less,Interest Expense @ 12%
0
6 000
Earnings Before Tax
10 000
4 000
Less,Tax @ 30%
3 000
1 200
Earnings Available for Distribution to Ordinary Shareholders
7 000
2 800
( No,of Ordinary Shares Issued
20 000
10 000
Earnings Per Share (EPS)
$0.35
$0.28
Plan 1 offers the higher EPS.
b)
Plan 1
Plan 2
Earnings Before Interest &Tax (EBIT)
$20 000
$20 000
Less,Interest Expense @ 12%
0
6 000
Earnings Before Tax
20 000
14 000
Less,Tax @ 30%
6 000
4 200
Earnings Available for Distribution to Ordinary Shareholders
14 000
9 800
( No,of Ordinary Shares Issued
20 000
10 000
Earnings Per Share (EPS)
$0.70
$0.98
Plan 2 offers the higher EPS.
c)
When EBIT = $12 000,EPS is $0.42 under both plans.
QUESTION 2
a)
Share Issue
Debenture Issue
Earnings Before Interest &Tax (EBIT)
$1 500 000
$1 500 000
Less,Interest Expense @ 12%
0
480 000
Earnings Before Tax
1 500 000
1 020 000
Less,Tax @ 30%
450 000
306 000
Earnings Available for Distribution to Ordinary Shareholders
1 050 000
714 000
( No,of Ordinary Shares Issued
300 000
200 000
Earnings Per Share (EPS)
$3.50
$3.57
See ATTACHED EBIT-EPS chart.
c)
d) Assuming that the company wishes to maximise EPS,it would prefer to finance the expansion program by an issue of ordinary shares if the EBIT are likely to be less than $1 440 000,If EBIT are equal to $1 440 000,the company would be indifferent between the equity and debt financing plans,The company would opt for a debenture issue if EBIT are expected to exceed $1 440 000.
Given that EBIT are projected to be $1.5 million,I would recommend that Lynch-Lyons Ltd fund the program by issuing debentures.
QUESTION 3
a)
Plan 1
Plan 2
Plan 3
Plan 4
EBIT
$1 000 000
$1 000 000
$1 000 000
$1 000 000
Less,Interest Expense
120 000
360 000
120 000
240 000
EBT
880 000
640 000
880 000
760 000
Less,Tax @ 30%
264 000
192 000
264 000
228 000
Earnings After Tax
616 000
448 000
616 000
532 000
Less,Preference Dividends
0
0
210 000
0
Earnings Available for Distribution to Ordinary Shareholders
616 000
448 000
406 000
532 000
( No,of Ordinary Shares Issued
4 500 000
3 000 000
3 000 000
3 750 000
EPS
13.7 cents
14.9 cents
13.5 cents
14.2 cents
b) Plans 1 and 2
Plans 1 and 4
Plans 2 and 4
c) Up to an EBIT of $840 000,Plan 1 (equity finance) maximises earnings per share (EPS),If EBIT exceed $840 000,Plan 2 (debenture issue) dominates all other plans in terms of EPS.
MODULE 7 - CAPITAL STRUCTURE
QUESTION 1
The Uthinko Company Ltd is comparing two different capital structures,an all-equity plan (Plan 1) and a levered plan (Plan 2),Under Plan 1,Uthinko would have 20 000 shares outstanding,Under Plan 2,Uthinko would have 10 000 shares and $50 000 in debt outstanding,The interest rate is 12% and the tax rate is 30%.
a) If EBIT is $10 000,which plan will result in the higher EPS?
b) If EBIT is $20 000,which plan will result in the higher EPS?
c) What is the breakeven EBIT,ie the indifference point for the 2 plans?
QUESTION 2
Lynch-Lyons Ltd has decided to finance a $4 million expansion program by issuing either ordinary shares or debentures,Currently the firm has 200 000 ordinary shares outstanding and no long-term debt,Ordinary shares can be sold to net $40 per share,The debenture issue will be a 25-year issue at 12% interest,The tax rate is 30%.
a) Assuming that the program will give rise to earnings before interest and taxes (EBIT) of $1.5 million,calculate the expected earnings per share (EPS) for the two (2) alternative financing plans.
b) Construct a simple EBIT-EPS graph which would indicate which of the financing plans should be preferred.
c) Calculate mathematically the breakeven level of EBIT,ie the indifference point for the two plans.
d) Comment on your graph in b) above and your answer to c) above.
QUESTION 3
Hi Grade Regulator Ltd has currently 3 million ordinary shares outstanding with a market price of $2 per share,It also has $2 million in 6% debentures,The company is considering a $3 million expansion program that it can finance in one (1) of four (4) ways:
Plan 1 All ordinary shares at $2 per share
Plan 2 Debentures at 8% interest
Plan 3 Preference shares at 7%
Plan 4 Half ordinary shares at $2 per share and half 8% debentures
a) For a hypothetical level of EBIT of $1 million,calculate the earnings per share (EPS) for each of the alternative methods of financing,Assume a tax rate of 30%.
b) Calculate the indifference points between:
- Plans 1 and 2
- Plans 1 and 4
- Plans 2 and 4.
c) Interpret your answers in b) above.
FIN2101 BUSINESS FINANCE II
SOLUTIONS TO TUTORIAL QUESTIONS
MODULE 7 - CAPITAL STRUCTURE
QUESTION 1
a)
Plan 1
Plan 2
Earnings Before Interest &Tax (EBIT)
$10 000
$10 000
Less,Interest Expense @ 12%
0
6 000
Earnings Before Tax
10 000
4 000
Less,Tax @ 30%
3 000
1 200
Earnings Available for Distribution to Ordinary Shareholders
7 000
2 800
( No,of Ordinary Shares Issued
20 000
10 000
Earnings Per Share (EPS)
$0.35
$0.28
Plan 1 offers the higher EPS.
b)
Plan 1
Plan 2
Earnings Before Interest &Tax (EBIT)
$20 000
$20 000
Less,Interest Expense @ 12%
0
6 000
Earnings Before Tax
20 000
14 000
Less,Tax @ 30%
6 000
4 200
Earnings Available for Distribution to Ordinary Shareholders
14 000
9 800
( No,of Ordinary Shares Issued
20 000
10 000
Earnings Per Share (EPS)
$0.70
$0.98
Plan 2 offers the higher EPS.
c)
When EBIT = $12 000,EPS is $0.42 under both plans.
QUESTION 2
a)
Share Issue
Debenture Issue
Earnings Before Interest &Tax (EBIT)
$1 500 000
$1 500 000
Less,Interest Expense @ 12%
0
480 000
Earnings Before Tax
1 500 000
1 020 000
Less,Tax @ 30%
450 000
306 000
Earnings Available for Distribution to Ordinary Shareholders
1 050 000
714 000
( No,of Ordinary Shares Issued
300 000
200 000
Earnings Per Share (EPS)
$3.50
$3.57
See ATTACHED EBIT-EPS chart.
c)
d) Assuming that the company wishes to maximise EPS,it would prefer to finance the expansion program by an issue of ordinary shares if the EBIT are likely to be less than $1 440 000,If EBIT are equal to $1 440 000,the company would be indifferent between the equity and debt financing plans,The company would opt for a debenture issue if EBIT are expected to exceed $1 440 000.
Given that EBIT are projected to be $1.5 million,I would recommend that Lynch-Lyons Ltd fund the program by issuing debentures.
QUESTION 3
a)
Plan 1
Plan 2
Plan 3
Plan 4
EBIT
$1 000 000
$1 000 000
$1 000 000
$1 000 000
Less,Interest Expense
120 000
360 000
120 000
240 000
EBT
880 000
640 000
880 000
760 000
Less,Tax @ 30%
264 000
192 000
264 000
228 000
Earnings After Tax
616 000
448 000
616 000
532 000
Less,Preference Dividends
0
0
210 000
0
Earnings Available for Distribution to Ordinary Shareholders
616 000
448 000
406 000
532 000
( No,of Ordinary Shares Issued
4 500 000
3 000 000
3 000 000
3 750 000
EPS
13.7 cents
14.9 cents
13.5 cents
14.2 cents
b) Plans 1 and 2
Plans 1 and 4
Plans 2 and 4
c) Up to an EBIT of $840 000,Plan 1 (equity finance) maximises earnings per share (EPS),If EBIT exceed $840 000,Plan 2 (debenture issue) dominates all other plans in terms of EPS.
