Question

After yesterday’s board meeting, Albany Construction Limited (ACL) agreed to change its current capital structure. The current capital structure of ACL is based on the view that no debt or a low level of debt is better than a high level of debt. Due to a change in the global business environment, ACL board members now believe that a high level of debt is necessary for the future growth of the company. ACL currently has a $200,000 long-term bank loan paying 9% interest. It also has 80,000 ordinary shares on issue under the current structure. The proposed capital structure will double the amount of the current bank loan to $400,000, but ACL will need to pay 12% interest. With this change, the number of ordinary shares on issue would reduce to 40,000 shares. ACL operates in the construction industry and the proposed capital structure is based on the industry average. ACL pays 28% tax on its income. Required: A. Assuming ACL expects EBIT of $120,000, what are the EPS for the current and proposed capital structures? Explain whether or not the board has made the right decision and justify your answer. [4 marks] B. Calculate the EBIT/EPS indifference point for EBIT. [3 marks] C. If ACL wishes to attain the highest EPS, over which range of EBIT is each capital structure preferred? [2 marks] D. Briefly explain the major shortcoming of EBIT/EPS analysis.

Answer 1

A) If ACL expects EBIT of $120,000.

calculation for current capital structure

Capital Structure Calculations
EBIT	120000
Interest @ 9%	18000
EBT	102000
TAX @ 28%	28560
PAT	73440
No of Shares	80000
Earnings Per Share	0.918	profit after tax/no of shares

Proposed capital Structure.

Capital Structure Calculations
EBIT	120000
Interest @ 12%	48000	Loan amount = 400,000
EBT	72000
TAX @ 28%	20160
PAT	51840
No of Shares	40000
Earnings Per Share	1.296	profit after tax/no of shares

The board has made correct decision as the greater interest on the loan is tax deductible. This along with lesser number of shares outstanding has helped the earnings per share to increase which will increase the value of the firm. So the board's decision is correct.

b) EBIT/EPS:

Current Capital Structure
EBIT	120000
EPS	0.918
EBIT/EPS	130718.9542
Proposed Capital Structure
EBIT	120000
EPS	1.296
EBIT/EPS	92592.59259

Point of indifference of EBIT is calculated as follows

Y = (x - interest) * (interest rate)/no of shares

Proposed Capital: Y = (x - 48000) * (0.28)/40,000

Current Capital: Y = (x - 18000) * (0.28)/80000

Multiply proposed capital by 40,000 and current capital by 80,000

we get 40,000Y = (x - 48000) * (0.28) and 80,000Y = (x - 18000) * (0.28)

by solving the above equation we get Y = 0.21

C) to calculate the break-even or the range of the EBIT-EPS, we will use the following formula

EBIT= (EPS*no of shares outstanding)/(1 - tax rate) * interest

for current capital structure: (0.918*80,000)/(1-0.28)*18000

= 73440/12,960 = 5.67

So the EBIT can be up to 5.67 times the EPS = 416,404

  

for proposed capital structure: (1.296*40000)/(1-0.28)*48000

= 51,840/34560 = 1.5

So EBIT can be up to 1.5 times the EPS = 77,760

D: Shortcomings:

a) Accounting data: Both the calculations rely on the accounting data which can be easily manipulated by the management by taking different accounting assumptions and calculations

b) Risk Analysis: While the accounting data gives us the EBIT and EPS calculations and with our example we can conclude that EPS is higher with higher debt. But it does not calculate the higher risk involved in raising higher debt, which is a major drawback.

c) Over leverage: As the interest on debt is tax deductible, companies can be ambitious to take up more debt to increase the EPS and give a positive outlook to the market, but the underline is that in phase of bad business environment, this strategy may back fire as company will have to pay up a lot of interest on debt.