Optimal Capital Structure: It is decided on the basis of market level not on the basis of company’s earnings. If market increases then company have to increase its debt capital in capital structure otherwise reduces it to achieve capital structure objectives i.e.
·
Minimizing the cost of capital.
·
Increases the Earnings Per Share (EPS).
Indifference
Point: It
is a level of Earnings Before Interest Tax (EBIT) where given capital structures
provide same Earnings Per Share (EPS).
Formula:
(EBIT-Interest) (1-Tax)/ Number of equity 1 =
(EBIT-Interest) (1-Tax)/ Number of equity2
Example: A company
X has outstanding debt of Rs.30, 00,000 @ 10% and equity of Rs.10, 00,000 of Rs.10
each. Company wants Rs.20, 00,000 to expand its business to fulfill the market
requirement. Find out the optimal capital structure with the help of following
information:
·
EBIT = Rs.50,00,000
·
Tax = 40%
·
Further capital raise through: Debt 8% or equity.
Solution:
Particulars
|
Case
1 (Fully Debt)
|
Case
2 (Fully Equity)
|
EBIT
|
50,00,000
|
50,00,000
|
Less:
interest
|
3,00,000
|
3,00,000
|
47,00,000
|
47,00,000
|
|
Less:
Interest
|
1,60,000
|
----
|
EBT
|
45,40,000
|
47,00,000
|
Less:
tax
|
18,16,000
|
18,80,000
|
Earnings
available for equity holders
|
27,24,000
|
28,20,000
|
Number
of equity
|
4,00,000
|
6,00,000
|
EPS
|
6.81
|
4.7
|
Example: Company
A suffer a loss and it have outstanding debt of Rs.10,00,000 and equity of
Rs.6,00,000.To handle this situation company reduces its capital structure.
Find out new capital structure. Other information is as follows:
·
EBIT = Rs.8,00,000
·
Tax = 30%
·
Debt reduces up to Rs.7,00,000
Solution:
Particulars
|
New Capital Structure
|
Old Capital structure
|
EBIT
|
8,00,000
|
8,00,000
|
Less: Interest
|
70,000
|
1,00,000
|
EBT
|
7,30,000
|
7,00,000
|
Less: tax
|
2,19,000
|
2,10,000
|
Earnings available for shareholders
|
5,11,000
|
4,90,000
|
Number of shares
|
60,000
|
60,000
|
EPS
|
8.51
|
8.16
|
The new capital
structure is Debt: Equity: 7:6.
Example: Company Y
has three options to raise further capital of Rs.60, 00,000:
·
Case 1: Fully equity of Rs.100 each.
·
Case 2: Fully debt @ 10%
·
Case 3: 3:2:1 ratios of debt @10%, equity Rs.100
each and preference share @ 8%.
Further information is:
·
EBIT = Rs. 12, 00,000
·
Tax: 40%
·
Outstanding equity of Rs. 20,00,000 of Rs.100
each
Find out which option gives highest EPS and also the next
best option of capital structure with the help of indifferent point.
Solution:
Particulars
|
Case 1
|
Case 2
|
Case 3
|
EBIT
|
12,00,000
|
12,00,000
|
12,00,000
|
Less: interest
|
------
|
6,00,000
|
2,00,000
|
EBT
|
12,00,000
|
6,00,000
|
10,00,000
|
Less: tax
|
4,80,000
|
2,40,000
|
4,00,000
|
Profit available for preference shareholders
|
7,20,000
|
3,60,000
|
6,00,000
|
Less: Preference dividend
|
------
|
-------
|
80,000
|
Profit available for shareholders
|
7,20,000
|
3,60,000
|
5,20,000
|
Number of shares
|
80,000
|
20,000
|
40,000
|
EPS
|
9
|
18
|
13
|
Indifference Point of case 2 and case 3:
(EBIT-Interest) (1-Tax)/ Number of equity 1 =
(EBIT-Interest) (1-Tax) –Dividend / Number of equity2
=(X – 6, 00,000) (1-0.40) / 20,000 = (X-2, 00,000) (1-0.40)
-80,000 / 40,000
= (X – 6, 00,000) (0.60) / 20,000 = (X-2, 00,000) (0.60)
-80,000 / 40,000
= 0.6X- 3, 60,000 / 1 = 0.6X- 1, 20,000 – 80,000 / 2
= 1.2X- 7, 20,000 = 0.6X- 1, 20,000 – 80,000
= 1.2X- 0.6X = -1, 20,000 + 6, 40,000
= 0.6X = 5, 20,000
=X = 8, 66,666.66
Particulars
|
Case 2
|
Case 3
|
EBIT
|
8,66,666.66
|
8,66,666.66
|
Less: interest
|
6,00,000
|
2,00,000
|
EBT
|
2,66,666.66
|
6,66,666.66
|
Less: tax
|
1,06,666.66
|
2,66,666.66
|
Profit available for preference shareholders
|
1,60,000
|
4,00,000
|
Less: Preference dividend
|
-------
|
80,000
|
Profit available for shareholders
|
1,60,000
|
3,20,000
|
Number of shares
|
20,000
|
40,000
|
EPS
|
8
|
8
|
Interpretation:
Case 2 gives the highest EPS in comparison of Case 1 and 3. The next best
option is Case 3 and if EBIT is Rs.8, 66,666.66 then the case2 and 3 give same
EPS of 8.
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