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Viyo Ltd.' is a company manufacturing textiles. It has a share capital of Rs 60 lakhs. The earnings per share in the previous year was Rs 0.50. For diversification, the company requires additional capital of Rs 40 lakhs. The company raised funds by issuing 10% debentures for the same. During the current year the company earned profit of Rs 8 lakhs on capital employed. It paid tax @ 40%.
a. State whether the shareholders gained or lost, in respect of earning per share on diversification. Show you calculations clearly.
b. Also, state any three factors that favour the issue of debentures by the company as part of its capital structure.
Kay Ltd. is a company manufacturing textiles. It has a share capital of Rs 60 lakhs. In the previous year its earnings per share was Rs 0.50. For diversification, the company requires additional capital of Rs 40 lakhs. The company raised funds by issuing 10% Debentures for the same. During the year the company earned profit of Rs 8 lakhs on capital employed. It paid tax @ 40%.
a. State whether the shareholders gained or lost, in respect of earning per share on diversification. Show you calculations clearly.
b. Also, state any three factors that favour the issue of debentures by the company as part of its capital structure.
Solution
(a) Let the face value of equity share be Rs 10 each.
Profit before Interest & Tax Rs 8,00,000
Interest on 10% debentures Rs 4,00,000
Profit before Tax Profit before Interest and Tax - Interest
Profit before Tax 8,00,000 - 4,00,000 Rs 4,00,000
Tax @ 40% `=4,00,000xx40/100= Rs 1,60,000`
Profit available to shareholders 4,00,000-1,60,000=Rs 2,40,000
Earning Per Share(EPS) =`"Profit after Tax"/"Number of Equity Share"=240000/600000=0.4`
Thus, shareholders have lost after the issue of debentures as earning per share (EPS) has fallen from Rs 0.5 to Rs 0.4.
(b) Three factors which favour the issue of debentures by the company as part of its capital structure:
1. Good cash flow position: If the company has a good cash flow position, then issuing debentures is more favourable as compared issuing shares.
2. High tax rate: It is beneficial for the company to issue debentures if the tax rate is higher. This is because the interest paid by the company to its debenture holders is tax deductible.
3. Control: If the company does not want to dilute the control of management, then issuing debentures is the best for the company.
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