Question

Vedansh Limited has a share capital of ₹10,00,000 divided into shares of ₹100 each.For expansion purposes, the company requires additional funds of ₹ 5,00,000. The management is considering the following alternatives for raising funds :

Alternative 1: Issue of 5000 Equity shares of ₹100 each

Alternative 2: Issue of 10% Debentures of Rs. 5,00,000 

The company’s present Earnings Before Interest and Tax ( EBIT) is ₹4,00,000 p.a. Assuming that the Rate of Return of Investment remains the same after expansion, which alternative should be used by the company in order to maximise the returns to the equity shareholders. The Tax rate is 50%. Show the working.

Answer 1

Rate of Return of Investment is `(4,00,000)/(10,00,000) xx 100 = 40%`

EBIT after expansion = `40% xx 15,00,000`

= 6,00,000

	Calculation of EPS
	Plan 1	Plan 2
EBIT	6,00,000	6,00,000
(-)Interest		50,000
EBT	6,00,000	5,50,000
(-)Tax(50%)	3,00,000	2,75,000
EAT.	3,00,000	2,75,000
No. Of shares.	15000.	10000
EPS.	20	27.5

The company should use Plan 2 in order to increase the return to the equity shareholders.