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Capital Structure 61
As the net income of the investor in company ‘Y’ is higher than the cost of income
from company ‘X’ due to switching the holding, the investor will gain in switching his
holdings to company ‘Y’.
Exercise 8
Paramount Products Ltd. wants to raise Rs. 100 lakh for diversification project. Current
estimates of EBIT from the new project is Rs. 22 lakh p.a.
Cost of debt will be 15% for amounts up to and including Rs. 40 lakh, 16% for additional
amounts up to and including Rs. 50 lakh and 18% for additional amounts above Rs. 50 lakh.
The equity shares (face value of Rs. 10) of the company have a current market value of
Rs. 40. This is expected to fall to Rs. 32 if debts exceeding Rs. 50 lakh are raised. The
following options are under consideration of the company.
Option Debt Equity
I 50% 50%
II 40% 60%
III 60% 40%
Determine EPS for each option and state which option should the Company adopt.
Tax rate is 50%. (ICWA Inter Dec. 1997)
Solution
I II III
Equity 50,00,000 60,00,000 40,00,000
Debt 50,00,000 40,00,000 60,00,000
Amount to be raised 1,00,00,000 1,00,00,000 1,00,00,000
EBIT 22,00,000 22,00,000 22,00,000
Less: Interest of Debt 7,60,000 6,00,000 9,40,000
PBT 14,40,000 16,00,000 12,60,000
Less : Tax @ 50% 7,20,000 8,00,000 6,30,000
PAT 7,20,000 8,00,000 6,30,000
No. of equity shares 1,25,000 1,50,000 1,25,000
Rs. 5.76 Rs. 5.33 Rs. 5.04
Working Notes
Calculation of Interest on Debt
Total Debt I II III
Interest on: 50,00,000 40,00,000 60,00,000
Ist Rs. 40,00,000 @ 15% 6,00,000 6,00,000 6,00,000
Next Rs.10,00,000 @ 16% 1,60,000 – 1,60,000
Balance Rs. 10,00,000 @ 18% – – 1,80,000
7,60,000 6,00,000 9,40,000