Question

QUESTION 2

Vistana Alam Company is a leading cosmetic company and wishes to raise capital for its new venture into cosmetic business. With favorable economic conditions, the company needs RM2 million to finance the project. A financial manager of the company is responsible to determine the best capital structure to raise the needed fund. Hence, he comes out with two possible financial plans, described as follows:

Sources / Plan	Plan 1 (Vistana Melati)	Plan 2 ( Vistani Puspa )
Common Stock	70%	20%
Debt	-	20%
Preferred Stock	30%	60%

Currently, the amount of shares outstanding is 500,000 and the manager proposes that any newly issued common shares would be RM25 per share. It also anticipates that the cost of using debt and preferred stock are 12 percent and 10 percent respectively. The corporate tax rate is 30 percent. You are required to answer the following questions

1. Calculate earnings before interest and taxes (EBIT) at the indifference level associated with both plans
2. Calculate earnings per share (EPS) at the point of indifference
3. If earnings before interest and taxes (EBIT) is RM3.2 million, which plan should be adopted? Justify your answer.

20 marks)

Answer 1

1)

Amount of shares outstanding = 500000

Capital required = 2000000

Plan 1

70% Common Stock = 1400000

30% Preferred Stock = 600000

New shares to be issued at 25 per share = 1400000/25 = 56000

Total shares outstanding = 500000 + 56000 = 556000

Prefered dividend at 10% = 600000*10% = 60000

Net Income = EBIT*(1-tax rate) = 0.7*EBIT

EPS = (Net Income - Prefered Dividend)/(Number of shares outstanding)

EPS = (Net Income - 60000)/556000

EPS = (0.7*EBIT - 60000)/556000

Plan 2

20% Common Stock = 400000

20% Debt = 400000

60% Preferred Stock = 1200000

New shares to be issued at 25 per share = 400000/25 = 16000

Total shares outstanding = 500000 + 16000 = 516000

Prefered dividend at 10% = 1200000*10% = 120000

Interest = 400000*12% = 48000

Net Income = (EBIT - Interest)*(1-tax rate) = 0.7*(EBIT - 48000)

EPS = (Net Income - Prefered Dividend)/(Number of shares outstanding)

EPS = (Net Income - 120000)/516000

EPS = (0.7*(EBIT - 48000) - 120000)/516000

Equating both EPS we have,

(0.7*EBIT - 60000)/556000 = (0.7*(EBIT - 48000) - 120000)/516000

Solving for EBIT we have

EBIT = 1,944,343

2)

EPS = (0.7*EBIT - 60000)/556000 = 2.34

3)

Plan 1 EPS = (0.7*EBIT - 60000)/556000

Substituting EBIT as 3200000, EPS = 3.92

Plan 2  EPS = (0.7*(EBIT - 48000) - 120000)/516000

Substituting EBIT as 3200000, EPS = 4.04

EPS(Plan 2) > EPS(Plan 1)

So, if EBIT is 3.2million, then Plan 2 should be adopted