(^310) Financial Management
Further assume that the existing EBIT are Rs 120, 000, the tax rate is 35 per cent,
outstanding ordinary shares' 10,000 and the market price per share is Rs 100 under all
the four alternatives.
Which financing plan should the firm select?
Solution
EPS under Various Financial Plans
The calculations in above table reveals that given a level of EBIT of Rs 1,20,000, the
financing alternative B, which involves 75 per cent ordinary shares and 25 per cent
debt, is the most favourable with respect to EPS. Another disclosure of the table is that
although the proliortion of ordinary shares in the total capitalization under the financing
plan D is also 75 per cent, that is, equal to plan B, EPS is considerably different (lowest).
The difference in the plans B and D is due to the fact that interest on debt is tax-
deductible while the dividend on preference shares is not. With 35 per cent income tax,
the explicit cost of preference shares would be higher than the cost of debt.
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 D 38,426
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.
Since preference dividend is not tax-deductible, we must divide the total dividends by
one, minus the tax rate, in order to obtain the EBIT necessary to cover these dividends
as a financial charge. Assuming a 35 per cent tax rate, preference dividend of Rs
25,000 can be paid on EBIT of Rs 38,462. The fixed financial charge would, therefore,
be higher. Earnings per share would be zero for plans B, C and D for the EBIT level of
Financing plans
A B C D
EBIT
Less Interest
Earnings before taxes
Taxes
Earning after taxes
Less preference dividend
Earnings available to ordinary shareholders
Number of Shares
Earnings per share (EPS)1,20,000- 1,20,000
42,000
78,000
78,000
20,000
3.9
1,20,000
25,000
95,000
33,250
61,750- 61,750
15,000
4.1
1,20,000
60,000
60,000
21,000
39,000- 39,000
10,000
3.9
1,20,000- 1,20,000
42,000
78,000
25,000
53,000
15,000
3.5