Links to Financial Management notes: -
Time Value of Money
https://gyanvikalpa.blogspot.com/2021/06/time-value-of-money-solved-problems-pdf.html
Leverage
Analysis
https://gyanvikalpa.blogspot.com/2021/08/financial-management-notes-leverage.html
Cost of
Capital
https://gyanvikalpa.blogspot.com/2021/08/cost-of-capital-solved-problems.html
EBIT –
EPS Analysis
https://gyanvikalpa.blogspot.com/2021/08/ebit-eps-analysis-financial-break-even.html
Capital
Structure Analysis
https://gyanvikalpa.blogspot.com/2022/02/capital-structure-theories-and-solved.html
Estimation
of Cash Flow in Capital Budgeting
https://gyanvikalpa.blogspot.com/2021/06/cash-flow-estimation-in-capital.html
Techniques
of Capital Budgeting
https://gyanvikalpa.blogspot.com/2021/06/techniques-of-capital-budgeting-solved.html
Capital Structure Planning and Designing
Getting an Exact optimal capital
structure is near to impossible and efforts should be made to achieve the best approximation
to the optimal capital structure. A capital structure for a firm should be
planned -
(a) To keep the financial risk of
the firm to a minimum level,
(b) To reflect the philosophy of
the management regarding control over the firm,
(c) To provide flexibility in the
ability of the firm to raise additional capital funds whenever needed, and
(d) To maximize the EPS of the
equity shareholders.
Two basic techniques available to
study the impact of a particular capital structure are - One from the point of
view of the profitability and the other from the point of view of liquidity.
Profitability and Capital Structure: EBIT-EPS analysis
Financial leverage affects the
pattern of distribution of operating profit among various types of investors
and increases the variability of the EPS of the firm.
Given a level of EBIT, EPS will be different under different financing
mix depending upon the extent of debt financing. The effect of leverage on the
EPS emerges because of the existence of fixed financial charge i.e. interest on
debt financing or fixed dividend on preference share capital.
The effect of fixed financial
charge on the EPS depends upon the relationship between the rate of return on
assets and the rate of fixed charge. If the rate of return on assets is higher than
the cost of financing, then the increasing use of fixed charge financing (i.e.,
debt and preference share capital) will result in increase in the EPS. This
situation is also known as favourable
financial leverage or Trading on Equity. On the other hand, if the rate of
return on assets is less than the cost of financing, then the effect may be
negative and therefore, the increasing use of debt and preference share capital
may reduce the EPS of the firm.
The fixed financial charge
financing may further be analyzed with reference to the choice between the debt
financing and the issue of preference shares. Theoretically, the choice is
tilted in favour of debt financing because of two reasons:
(I) the explicit cost of debt
financing i.e., the rate of interest payable on debt instruments or loans is
generally lower than the rate of fixed dividend payable on preference shares, and
(II) Interest on debt financing is
tax-deductible and therefore the real cost (after-tax) is lower than the cost
of preference share capital.
EBIT- EPS analysis is of
significant importance and if undertaken properly, can be an effective tool in
the hands of a financial manager to get an insight into the planning and
designing the capital structure of the firm. The profits
of the firms vis-a-Vis the burden of debt financing should also be analyzed.
The debt capacity or ability of the firm to service the debt can be analyzed in
terms of the coverage ratio, which shows the relationship between EBIT and the
fixed financial charge.
Interest coverage ratio may be calculated
as follows:
Interest Coverage Ratio = EBIT / Interest.
Together with the
EBIT EPS analysis for different levels of debt financing, interest
coverage ratio may also be calculated for different levels of financial
leverages.
Liquidity and Capital Structure: Cash Flow analysis
A company (although earning
sufficient profits) may not be generating large enough cash surplus, perhaps
due to the needs to re-invest heavily in working capital. Such a firm will find
it difficult to service fixed interest and preference dividend. If it is so,
then the firm may resort to equity financing where dividend tends to be lower
and can be reduced or skipped if the cash is scarce. Companies which can generate
large cash surplus from their operations will tend to opt for larger debt
financing.
A finance manager, while evaluating
different capital structure, should also find out the liquidity required for-
(i) Interest on debt,
(ii) Repayment of debt,
(iii) Dividend on preference share
capital, and
(iv) Redemption of preference share
capital
The requirement of liquidity should
then be compared with the cash availability from operations of the firm as
follows-
1. Debt Service Coverage Ratio (DSCR):
In the Debt Service Cover age Ratio
(DSCR), the cash profits generated by the operations are compared with the
total cash required for the service of the debt and the preference share
capital.
DSCR = (PAT + Depreciation +Interest + Non-Cash expenses) / (Pref.
Dividend + Interest + Repayment obligation)
In the above equation, Pref.
Dividend may be taken as inclusive of the Corporate Dividend Tax. The DSCR
helps in assessing the extent to which cash profits of the firm covers the cash
obligations for revenue nature payments as well as the capital nature payments.
The higher the DSCR, the better it is and the firm will face no financial
difficulty in meeting its obligations.
2. Projected Cash flow Analysis:
The firm may also undertake the
cash flow analysis for the period under consideration. This will enable the
financial manager to assess the liquidity capacity of the firm to meet the
obligations of interest payments and the repayment of principal obligations. A
projected cash budget may be prepared to find out
the expected cash inflows and cash outflows including interest and repayments).
If the inflows are comfortably higher than the outflow, then the firm can
proceed with the debt financing. A firm may have three
types of cash flows:
(i) Those relating to operations of
the firm.
(ii) Cash flows relating to capital
nature transactions and
(iii) Financial flows relating to
interest, dividend and repayments etc.
In the projected cash flow
analysis, all these cash flows are to be considered.
Difference between the expected
cash flows under different operating conditions and the cash outflows including
those required for debt and preference capital servicing should be identified.
If the differences are within specified limits, the firm may proceed with the
proposed capital structure.
EBIT-EPS Analysis versus Cash flow Analysis (i.e. Profitability versus
Liquidity)
|
EBIT – EPS Analysis |
Cash Flow Analysis |
|
Evaluated on the basis of profitability of shareholders. Capital
structure which results in maximization of EPS is selected.
Financial leverages at different levels are considered so as to find
out their effect on the EPs. |
Liquidity side of leverage is stressed. Capital structure is evaluated
in the light of available liquidity. The firm need not face any liquidity
problem in debt servicing. |
|
It stresses the profitability of the proposed financing mix and
analyses it from the point of view of equity shareholders. |
It looks upon a financing mix and stresses the need for liquidity
requirement of debt financing and thus, it emphasizes the debt investor. |
Financial Distress
Financial distress is a situation
when a firm finds it difficult to honour its commitment to creditors/ debt
holders. With reference to capital structure, the financial distress refers to the
Situation when the firm faces difficulties in paying interest and principal repayments
to the debt investors. Financial distress arises when the fixed financial obligations
of the firm affect firm's normal operations. For example, if a firm has to
dispose-off some of its assets to meet the interest obligations, the firm is
said to be in financial distress.
There are many degrees of financial
distress. One extreme degree of financial distress is bankruptcy, a condition
in which the firm is unable to meet its financial obligation and faces
liquidation. However, still the debt financing is used almost unexceptionally
because it brings benefits in the form of tax-shield. As a result, the firm
should try to achieve a trade-off between the costs and benefits of debt financing
- the cost being the financial distress and the benefits being the interest
tax-shield. The cost of financial distress is reflected in the
market value of the firm and can be measured through its effect on the value of
the firm. Lower levels of leverage will have little effects, but as the
financial leverage increases, the cost of financial distress increases and the
market value of the debt as well as equity falls.
1. The income statement
of ABC Ltd. is as follows:-
|
|
Amount in Crores |
|
Sales |
500 |
|
Less: Cost of Goods sold (including Depreciation) |
250 |
|
Less: Selling & Distribution Expenses |
(50) |
|
EBIT |
200 |
|
Less: Taxes @50% |
(100) |
|
Net income - EBIT (1 –
t ) |
100 |
The company's cost of
capital is 12% and its net assets are worth Rs. 800 crores.
I. What is the conventional return on investment?
II. What is net addition
to the wealth of shareholders in the current year in terms of Economic Value
Added?
Solution
Conventional return on Investment =
Net Income / Net Assets
= 100 / 800 =0.125 = 12.5 %
Economic Value added = Net Income –
Cost of Capital employed
= 100 – (800 × .12) = 4 Crore
2. Tara industry is
attempting to establish a current assets policy. Fixed assets are Rs. 20 lakhs
and the firm plans to maintain a 50% debt-to-assets ratio. The interest rate is
10% on all debts. Three alternative current assets (CA) policies are under consideration-
20%, 30% and 40% of projected sales. The company expects to earn 15% before
interest and taxes on sales of 50 lakhs. Effective tax rate is 50%. What is the
expected return on equity under each alternative?
Solution
|
|
40 % CA |
50 % CA |
60 % CA |
|
Sales |
50,00,000 |
50,00,000 |
50,00,000 |
|
Fixed Assets |
20,00,000 |
20,00,000 |
20,00,000 |
|
Current Assets |
10,00,000 |
15,00,000 |
20,00,000 |
|
Total Assets |
30,00,000 |
35,00,000 |
40,00,000 |
|
Debt Asset Ratio |
.50 |
.50 |
.50 |
|
Hence, Debt |
15,00,000 |
17,50,000 |
20,00,000 |
|
Interest @ 10 % |
1,50,000 |
1,75,000 |
2,00,000 |
|
EBIT @ 15 % of Sales |
7,50,000 |
7,50,000 |
7,50,000 |
|
Less: Interest |
(1,50,000) |
(1,75,000) |
(2,00,000) |
|
EBT |
6,00,000 |
5,75,000 |
5,50,000 |
|
Less: Tax @ 50 % |
(3,00,000) |
(2,87,500) |
(2,25,000) |
|
PAT |
3,00,000 |
2,87,500 |
2,25,000 |
|
Equity |
15,00,000 |
17,50,000 |
20,00,000 |
|
Return on Equity |
0.2 |
.1643 |
.1125 |
Value of Equity = Total Assets – Debt
Expected Return on Equity = PAT / Value of Equity
Since value of Net Income is
maximum in case of 20 % Current Asset scenario. Hence Current Assets of 20 % of
sales should be maintained.
3. Jiva Ltd is contemplating conversion of 500 -
15% convertible bonds of Rs. 1,000 each. Market price of the bond is Rs.1080.
Bond indenture provides that one bond will be exchanged for 10 shares. Price
earning ratio before redemption is 20:1 and anticipated price-earning ratio
after redemption is 25:1. Number of shares outstanding prior to redemption are
10,000. EBIT amounts to Rs. 2,50,000. The company is in the 50 % tax bracket.
Should the company convert bonds into shares? Give reasons.
Solution
|
|
Present Scenario |
After Conversion |
|
EBIT |
2,50,000 |
2,50,000 |
|
Less: Interest @ 15 % |
(75,000) |
--------- |
|
EBT |
1,75,000 |
2,50,000 |
|
Less: Tax @ 50 % |
(87,500) |
(1,25,000) |
|
PAT |
87,500 |
1,25,000 |
|
No. of outstanding shares |
10,000 |
15,000 |
|
EPS |
8.75 |
8.33 |
|
P/E Ratio |
20 |
25 |
|
Market Price (MPS) |
175 |
208.33 |
EPS = PAT / Number of outstanding
shares
P/E Ratio = MPS / EPS
Interest = 15 % of Rs. 5,00,00 (500
×Rs.1,000 ) =
Rs. 75,000.
Yes, the company should opt for
conversion of bonds into equity shares as this will result in increase in
market price of the share from Rs. 175 to Rs. 208.33.
4. XYZ Ltd. has issued
convertible debentures with interest rate of 15%. Every debenture has an option
to convert to 25 equity shares now. Debentures will be redeemed at Rs. 102 on
maturity after 5 years. An investor normally requires a rate of return of 10 %
p.a. on a five years security. As an investor, would you exercise conversion at
present if the market price of equity shares is (i) Rs. 4 (ii) Rs. 5 (iii) Rs. 6?
Solution
Value of Debentures in case of non-conversion
–
Present Value (PV) of interest of
Rs. 15 for 5 years at 10 % = Rs. 15 × PVAF0.1, 5
= Rs. 15 × 3.791 = Rs. 56.87
PV of redemption value of Bond =
Rs. 1020 × PVF0.1,
5 = Rs. 102 ×
.621 = Rs.63.34
Total PV of Bond = Rs. 56.87 +
Rs.63.34 =
Rs.120.21
Value of Equity Shares if debenture is
converted now
|
Market Price of Shares |
No. of shares for one debenture |
Value of Share |
|
4 |
25 |
100 |
|
5 |
25 |
125 |
|
6 |
25 |
150 |
Debenture conversion should be
opted if market price of Share now is either Rs. 5 or Rs. 6 as in both cases,
current market value of share is greater than present value of debenture.
5. Current situation
of Vigyan Ltd, producer of turbine generators, is as follows:
|
EBIT |
Rs. 50,00,000 |
|
Tax rate |
50% |
|
Debt |
Rs. 30,00,000 |
|
Rate of Interest |
10% |
|
Cost of Equity (Ke) |
15% |
|
Number of Shares Outstanding |
10,00,000 |
|
Book value per share |
Rs. 10 |
Vigyan’s product market
is stable and the company expects no growth, all earnings are paid out as
dividends. The debt consists of perpetual bonds. What are its Earning per Share
(EPS) and its price per share? It can increase its debt by Rs. 45 lakhs, to a
total of Rs. 75,00,000 to buy back and retire some of its shares at the current
price. Its interest rate on debt will be 12% (it will have to call and refund
the old debt), and its cost of equity will rise from 15% to 17%. EBIT will
remain constant. Should Vigyan change its capital structure?
Solution
|
Current Scenario: Calculation of EPS & MPS |
|
|
EBIT |
50,00,000 |
|
Less: Interest |
(3,00,000) |
|
EBT |
47,00,000 |
|
Less: Tax @ 50 % |
(23,50,000) |
|
PAT |
23,50,000 |
|
No. of Shares |
10,00,000 |
|
EPS or DPS = PAT/ No. of Shares |
2.35 |
|
Market Price (MPS) = DPS/ Ke = 2.35/.15 |
15.67 |
If the company decides to increase
debt by Rs. 45 lakhs, it has to buy back 45,00,000 / 15 = 2,87,173 shares
Now total number of shares will be
10,00,000 - 2,87,173 =7,12,827
The market price of the share will
be ascertained as follows:
|
Particulars |
|
|
EBIT |
50,00,000 |
|
Less: Interest 12 % of 75,00,000 |
(9,00,000) |
|
EBT |
41,00,000 |
|
Less: Tax @ 50 % |
(20,50,000) |
|
PAT |
20,50,000 |
|
No. of Shares |
7,12,827 |
|
EPS or DPS as per the question |
2.88 |
|
Market Price (MPS) = DPS/ Ke = 1.58/.17 |
16.94 |
As the price is expected to go up
from Rs. 15.67 to Rs. 16.94, the company should change its current capital
structure and adopt new financing mix.
6. Rajesh Ltd. is engaged
in expansion of its production capacity which is expected to increase its
operating profits from 15 % to 20 %. The proposal requires additional funds of Rs.
1,00,00,000 for which different alternatives of raising funds are being evaluated.
These are:
|
|
Option I |
Option II |
Option III |
Option IV |
|
14% Pref. Sh. Capital |
20 Lakh |
20 Lakh |
------ |
10 Lakh |
|
Equity Share Capital (FV = Rs. 10) |
40 Lakh |
20 Lakh |
20 Lakh |
50 Lakh |
|
14% Partly Conv. Debentures |
------ |
------ |
30 Lakh |
----- |
|
16% Debentures |
------ |
20 Lakh |
------- |
40 Lakh |
|
20% Term Loan (TL) |
------ |
40 Lakh |
50 Lakh |
------ |
|
22% Term Loan (TL) |
40 lakh |
------ |
------- |
------ |
Additional Information:
(i) The Company belongs
to 50% tax bracket.
(i) 50% of partly convertible
debentures are to be converted into Equity share capital at par at the end of 4th
year.
Evaluate different options
of raising the required funds in view of the fact that the firm wants to
maximise the dividends to the shareholders (100% payment ratio) and the period
of 3 years is considered sufficient for capital structure division.
Solution
In this case, the firm has
different options of capital structure. In option II, partly convertible
debentures are to be converted in equity shares only after 5 years. But the
period of 3 years is considered sufficient for capital structure decision.
Therefore, conversion of partly convertible debentures after 5 years becomes
irrelevant. The return to equity shareholder under different options can be
calculated as follows-
|
|
Option I |
Option II |
Option III |
Option IV |
|
Capital employed |
1,00,00,000 |
1,00,00,000 |
1,00,00,000 |
1,00,00,000 |
|
EBIT @ 20 % |
20,00,000 |
20,00,000 |
20,00,000 |
20,00,000 |
|
Less: Int. on 14%
partly convertible debenture |
|
|
(4,20,000) |
|
|
Less: Int. on 16 % Deb. |
|
(3,20,000) |
|
(6,40,000) |
|
Less: Int. on 20% TL |
|
(8,00,000) |
(10,00,000) |
|
|
Less: Int. on 22 % TL |
(8,80,000) |
|
|
|
|
EBT |
11,20,000 |
8,80,000 |
5,80,000 |
13,60,000 |
|
Less: Tax @ 50% |
(5,60,000) |
(4,40,000) |
(2,90,000) |
(6,80,000) |
|
PAT |
5,60,000 |
4,40,000 |
2,90,000 |
6,80,000 |
|
Less: Pref. Dividend |
(2,80,000) |
(2,80,000) |
|
(1,40,000) |
|
Earnings available for
ESH |
2,80,000 |
1,60,000 |
2,90,000 |
5,40,000 |
|
No. of Equity Shares |
4,00,000 |
2,00,000 |
2,00,000 |
5,00,000 |
|
DPS |
.7 |
.8 |
1.45 |
1.08 |
Option Ill is best because the
dividend payable to Equity Shareholders (ESH) is highest in this case. Result
indicates that the firm has an opportunity to avail maximum benefit of cheaper
debt financing using third option.
Links to Financial Management notes: -
Time Value of Money
https://gyanvikalpa.blogspot.com/2021/06/time-value-of-money-solved-problems-pdf.html
Leverage Analysis
https://gyanvikalpa.blogspot.com/2021/08/financial-management-notes-leverage.html
Cost of Capital
https://gyanvikalpa.blogspot.com/2021/08/cost-of-capital-solved-problems.html
EBIT – EPS Analysis
https://gyanvikalpa.blogspot.com/2021/08/ebit-eps-analysis-financial-break-even.html
Capital Structure Analysis
https://gyanvikalpa.blogspot.com/2022/02/capital-structure-theories-and-solved.html
Estimation of Cash Flow in Capital Budgeting
https://gyanvikalpa.blogspot.com/2021/06/cash-flow-estimation-in-capital.html
Techniques of Capital Budgeting
https://gyanvikalpa.blogspot.com/2021/06/techniques-of-capital-budgeting-solved.html
