Capital Structure Theories^299
Which financing plan should the firm select?
Solution
EPS Under Various Financial Plans
The calculations in Table reveal that given a level of EBIT of Rs.1,20,000, the financing
alternative B, which involves 50 per cent ordinary shares and 50 per cent debt, is the
most favourable with respect to EPS.
Table also indicates that the annual before-tax costs of the various financing plans
are:
- Financing Plan B Rs.25,000
- Financing Plan C 60,000
Financing plan A involves no cost as there is no fixed financial charge. That the
financing plan involves a specific amount of cost, is another way of saying that an equal
amount of earnings before interest and taxes is necessary to cover the fixed financial
charges. Earnings per share would be zero for plans B, C for the EBIT level of
Rs.25,000, Rs.60,000 respectively. This level of EBIT may be termed as financial
break even (BEP) level of earnings before interest and taxes because it represents the
level of EBIT necessary for the firm to break even on its fixed financial charge. In
other words, it is the level of EBIT at which the firm can satisfy all fixed financial
charges (i.e. interest and preference dividend). EBIT less than this level will result in
negative EPS. The financial break-even point can be determined by Eq.
Financial break-even point = 1 t1 Dp+where I =Annual interest charges
DP = Preference dividend
T =Tax rateParticulars Financing Plans
A B C
Rs 1,20,000
-------Rs 1,20,000
25,000Rs 1,20,000
60,000
1,20,000
42,00095,000
33,25060,000
21,000
78,000
------61,750
------39,000
------EBIT
Less: Interest
Earnings before taxes
Taxes
Earnings after taxes
Less: Preference dividend
Earnings available to ordinary shareholders
Number of shares
Earnings per share (EPS)78,000
20,000
3.961,750
15,000
4.139,000
10,000
3.9