Question

The present capital structure of Ali Co. ltd. is: 4000, 5% Debentures of $ 100 each $ 4,00,000 2000, 8% P. Shares of $ 100 each $ 2,00,000 4000, Equity shares of $100 each $ 4,00,000 $ 10,00,000 The present earning of the company before interest & taxes are 10% of the invested capital every year. The company is in need of $ 2,00,000 for purchasing a new equipment and it is estimated that additional investment will also produce 10% earning before interest & taxes every year. The company has asked your advice as to whether the requisite amount be obtained in the form of 5% Debenture or 8% P. Shares Or equity shares of $ 100 each to be issued at par. Examine the problem in all its bearing and advice firm if the Corporate tax rate is 50%.

Answer 1

Current capital structure of Ali co Ltd

4000 5%debenture of 100 each	400000
2000 8% preference shares of 100 each	200000
4000 equity share of 100 each	400000
Total	1000000

Earnings before interest and tax( EBIT) =10 % on capital invested

Company requires 200000 more funds to purchase equipment from which source it should rise fund to maximize profit.

So , EBIT after new fund rise would be =(1000000+200000)*10%

=120000$

If new fund is rised by equity share than number of equity share also increase by 2000(200000/100)

New share under rise fund form equity become 6000(4000+2000)

Main target of fiance management is to maximize wealth of shareholders .so the option has maximum eps ( earnings per share ) would be selected

So fund rise under debenture option is the best because this option has maximum earnings per share (eps)