Question

2. (A)​A Salalah Mills SAOG company presently is having rational Earnings before interest and tax. This company needs long-term sources of funds for installation of a new factory. The new factory expects to yield annual earnings before interest and tax of OMR 500,000. In choosing a financial plan, Salalah Mills Company has an objective of maximizing earnings per share (EPS). The company proposes to issuing ordinary shares and raising debt of 20% or 60% of the required funds. The market price per share is estimated at OMR 10.000 and is expected to rise up to OMR 15.000 per share if the funds are borrowed in excess of OMR 2,400,000. This company needs OMR 6,000,000 long term funds.
​Funds can be raised at the following rates.    ​
​-Up to OMR 600,000 at 4.5%
​-Over OMR 600,000 to OMR 3,000,000 at 7.5%
​-Over OMR 3,000,000 at 9.5%
​Assume that the corporate tax rate is 15%.
​As a financial analyst, compute earnings per share under different levels of debt ​financing by following Traditional Approach of Capital Structure. Advise the ​company how to optimize the its value by using debt financing.

Answer 1

	Option 1	Option 1
	80% Shares & 20% debts	40% Shares & 60% debts
Total Funds Required	6,000,000	6,000,000
Borrowed Funds in %	20%	60%
Borrowed Funds (Total required funds * %)	1,200,000	3,600,000
Equity Remaining value	4,800,000	2,400,000
Estimated Market price of Share	10	15
Number of Shares (Equity / Per share price)	480,000	160,000
Profit Before Interest & tax	500,000	500,000
Interest on Borrowed Funds (Funds * rate of Interest)	90,000	324,000
After Interest Profit (Profit before interest - Interest)	410,000	176,000
Less: Tax (15% on after Interest profit)	61,500	26,400
Profit after Tax	348,500	149,600
Earning Per Share (Profit after tax / number of shares)	0.73	0.94

Company will be optimise its value by using debt finance as EPS increase when Debts is higher.