Question

A firm is contemplating investment to the tune of Rs.750 million on an expansion plan. The firm’s current ROI is 20%, and the proposed investment will improve it to 25%. The current investment is Rs.1000 million. The firm’s current debt to equity ratio is 1:1. The existing cost of debt at 15%. The equity share capital is represented by 10 million shares, which are currently traded at Rs.300 per share. New debt can be raised at 18% and new equity shares cannot be issued at a price more than the current market price. Perform EPS-EBIT analysis for choosing between the options 100% debt and 100% equity for financing the proposed expansion. The applicable corporate tax rate is 30%.

Answer 1

Investment to be made = 750 million

Current Investment = 1000 million

Current debt to equity is 1:1 i.e Equity 500 million and debt of 500 million

Current Cost of Debt = 15% , New Cost of Debt = 18%

Current No. of shares = 10 million i.e face Value is 500/10 = 50

Current Maret Price of shares = 300

Current Market Capitalisation (value of Equity ) = 10 million * 300 = 3000 million

Tax rate = 30%

	Plan A (100% Equity)	Plan B (100% Debt)
Equity	No of shares = Old + New = 10 million + 750million/300 = 10 million + 2.5 million = 12.5 million Face Value of shares = 50 Face Value of All shares = 625 million Share Price = 300 Market Value of all shares = =12.5 million * 300 = 3750 million	No of shares =  10 million Face Value of shares = 50 Face Value of All shares = 500 million Share Price = 300 Market Value of all shares = =10 million * 300 = 3000 million
Debt	500 Million Cost of debt 15%	500 million @ 15% cost of debt 750 million @ 18% cost of debt

EBIT - EPS Analysis

Basically it says till a point of EBIT , Equity Option is Better.

However after that point of EBIT (as EBIT increases) , Debt Option is Better. (As Financial Leverage exists)

At that point which is mentioned, is Indifference Point which yields same EPS in both the Option (equity/ debt)

EBIT - EPS Indifference point

EPS as per Plan A = EPS as per Plan B

(EBIT - Interest Expense in Plan A ) * (1- Tax rate) Divided by no. of shares in Plan A = (EBIT - Interest expense in Plan B) * (1-Tax rate) Divided by no. of shares in Plan B

(EBIT - 500 *15%)* (1-30%) Divided by 12.5 = (EBIT - 500*15% - 750 *18%)* (1-30%) Divided by 10

(EBIT - 75 ) *70% Divided by 12.5 = (EBIT - 75 - 135 ) *70% Divided by 10

(EBIT - 75 ) *10 = (EBIT - 210) *12.5

10EBIT - 750 = 12.5 EBIT - 2625

2.5 EBIT = 1875

EBIT = 750

(Everything is taken in Million)

Thus At EBIT 750 million both the Plans yield same EPS.

EBIT below 750 million, Plan A (Equity is better)

EBIT above 750 million, Plan B (Debt is better)

Depends on what EBIT Level Company operates, accordingly decision should be taken.

Happy Learning!