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Question
Sunrises Ltd. dealing in readymade garments, is planning to expand its business operations in order to cater to international market. For this purpose the company needs additional Rs. 80,00,000 for replacing machines with modern machinery of higher production capacity. The company wishes to raise the required funds by issuing debentures. The debt can be issued at an estimated cost of 10%. The EBIT for the previous year of the company was Rs. 8,00,000 and total capital investment was Rs. 1,00,00,000. Suggest whether issue of debenture would be considered a rational decision by the company. Give reason to justify your answer. (Ans. No, Cost of Debt (10%) is more than ROI which is 8%).
Solution
A company can issue debenture for raising fund if the cost of the debt is less then cost of capital.
In this case, the cost of capital for sunrises limited is 10%, for the total capital of 80,00,000, cost of capital will be 8,00,000 INR.
As per the previous year earnings statement, the company had net earnings of 8,00,000 for the capital investment of 1,00,00,00 , so total ROI for that is mentioned below
`"ROI"= "RETURN" / "INVESTMENT"`
`"ROI" = 800000/10000000 = 8` Percent
Under the assumption that company will operate under the same efficiency, the additional investment of 80,00,000 will be having net ROI of 8% which will be 6,40,000 aganist the cost of debt 8,00,000.
As for the project the cost of debt is 10 % which is generating ROI of 8% , it would not be advisable decision for a company to issue debenture when cost of debt is higher than cost of capital.
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