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 outstand ing. The interest rate is 12% and the tax rate is 30% 1) 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? 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. Ord inary 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 e) 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
September 2003 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 outstand ing 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 l shares at $2 per share per Plan 2 Debentures at 8% interest Plan 3 Preference shares at 7% Plan 4 Half ord inary shares at $2 per share and half 8% debentures 1) For a hypothetical level of EBIT of $1 million, calculate the earnings per share(EPS) or 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 Interpret your answers in b)above
September 2003 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
September 2003 FIN2101 BUSINESS FINANCE II SOLUTIONS TO TUTORIAL QUESTIONS MODULE 7 - CAPITAL STRUCTURE
QUESTION 1 Plar Plan 2 Earnings Before Interest &Tax(EBIT) $10000 10000 Less: Interest Expense 12% 6000 Earnings Before Tax 10000 4000 ess:Tax@ 309 3000 Earnings Available for Distribution to 7000 Ord inary Shareholders No of Ordinary Shares Issued 20000 10000 Earnings Per Share(EPS) 0.35 s0.28 Plan l offers the higher EPS Plan l Plan 2 Earnings Before Interest &Tax(EBIT) $20000 20000 Less: Interest Expense 12% 6000 Earnings Before Tax Less: Tax@ 30% 6000 4200 Earnings Available for Distribution to 14000 9800 Ord inary Shareholder No of Ordinary Shares Issue 20000 10000 Earnings per Share(EPS) 0.70 s0.98 Plan 2 offers the higher EPs (X-0X1-0.3)-0(X-60004-03)-0 20000 10000 0.7X0.7X-4200 7X=14X-84000 7X=-84000 X=$12000 When EBIT= $12 000, EPS is $0. 42 under both plans
September 2003 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) ( )( ) ( )( ) X $12 000 - 7X - 84 000 7X 14X - 84 000 10 0.7X - 4 200 20 0.7X 10 000 X - 6 000 1- 0.3 - 0 20 000 X - 0 1- 0.3 - 0 = = = = = When EBIT = $12 000, EPS is $0.42 under both plans
QUESTION 2 Share Issue Debenture Issue Earnings Before Interest & Tax(EBIT) $1 500000 I500000 Less: Interest Expense@ 12% 48000 Earnings before Tax 1500000 1020000 Less: Tax(@ 30% 450000 306000 Earnings available for Distribution to 1050000 714000 Ord inary shareholders No of Ordinary Shares Issued 300000 200000 Earnings Per Share(EPs S350 $3.57 b) See ATTACHED EBIT-EPS chart (X-1)(1-T)-PD_(X-2)(-T)-PD2 (x-0)(-03)0(×-48000403-0 300000 200000 07X0.7X336000 14X=2.1X-1008000 -0.7X=-1008000 X=$1440000 EPS=$3.36 d) Assuming that the company wishes to maximise EPS, it would prefer to finance the expansion program by an issue of ord inary 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
September 2003 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 b) See ATTACHED EBIT-EPS chart. c) ( )( ) ( )( ) ( )( ) ( )( ) EPS = $3.36 X = $1440 000 - 0.7X = -1008 000 1.4X = 2.1X -1008 000 2 0.7X - 336 000 = 3 0.7X 200 000 X - 480 000 1- 0.3 - 0 = 300 000 X - 0 1- 0.3 - 0 N X - I 1- T - PD = N X - I 1- T - PD 2 2 2 1 1 1 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 LynchLyons Ltd fund the program by issuing debentures
QUESTION 3 Plan l Plan 2 Plan 3 Plan 4 EBIT sl00090000100000000 Less: Interest Expense 20000360000 120000240000 EBT 88006400008800076000 Less: Tax(@ 30% 264000 192000 64000 228000 Earnings after Tax 616000448000 616000 532000 Less. Preference dividends 0210000 Earnings Available for Distribution 616000 448000 406000532000 to Ordinary shareholders No of Ordinary Shares Issued 450000300003000003750000 EPS 13.7 14.9 cents 13.5 cents 14.2 cents Plans i and 2 (x-1)(T),PD12(x-12)(.T)PD N (X-120000.3)-0_(xX-360000(-03)-0 4500000 3000000 0.7X-840000.7X-252000 4.5 2.1X-252000=3.15X-1134000 1.05X=-882000 X=$840000 EPS=11.2 cents
September 2003 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 ( )( ) ( )( ) ( )( ) ( )( ) EPS =11.2 cents X = $840 000 -1.05X = - 882 000 2.1X - 252 000 = 3.15X -1134 000 3 0.7X - 252 000 = 4.5 0.7X - 84 000 3 000 000 X - 360 000 1- 0.3 - 0 = 4 500 000 X -120 000 1- 0.3 - 0 N X - I 1- T - PD = N X - I 1- T - PD 2 2 2 1 1 1
Plans i and 4 -I1)(1-T)-PD1(X-1,)(-T)-PD4 (X-12000-0.3)-0_(xX-24000(1-0.3)-0 4500000 3750000 0.7X-840000.7X-168000 4.5 3.75 2.625X-315000=3.15X-756000 0.525X=-441000 X=$840000 EPS=11.2 cents Plans 2 and 4 (x-l2)(-T)-PD2x-1)(-T)-P (X-360000(-0.3)-0_(X-240004-0.3)-0 3000000 3750000 0.7X-2520000.7X-168000 3.75 2.625X-945000=2.1X-504000 0.525X=441000 EPS=l1.2 cents Up to an EBIT of $840 000, Plan 1(equity finance) max mises earnings per share (EPS). If EBIT exceed $840 000, Plan 2(debenture issue)dominates all other plans in terms of ePs
September 2003 Plans 1 and 4 ( )( ) ( )( ) ( )( ) ( )( ) EPS =11.2 cents X = $840 000 - 0.525X = - 441000 2.625X - 315 000 = 3.15X - 756 000 3.75 0.7X -168 000 = 4.5 0.7X - 84 000 3 750 000 X - 240 000 1- 0.3 - 0 = 4 500 000 X -120 000 1- 0.3 - 0 N X - I 1- T - PD = N X - I 1- T - PD 4 4 4 1 1 1 Plans 2 and 4 ( )( ) ( )( ) ( )( ) ( )( ) EPS =11.2 cents X = $840 000 0.525X = 441000 2.625X - 945 000 = 2.1X - 504 000 3.75 0.7X -168 000 = 3 0.7X - 252 000 3 750 000 X - 240 000 1- 0.3 - 0 = 3 000 000 X - 360 000 1- 0.3 - 0 N X - I 1- T - PD = N X - I 1- T - PD 4 4 4 2 2 2 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