Module07Tutorial.doc

September 2003FIN2101 BUSINESS FINANCE IIMODULE 7 - CAPITAL STRUCTUREQUESTION 1The Uthinko Company Ltd is comparing two different capital structures, an all-equity plan (Plan 1) and a levered plan (Plan 2). Under Plan 1, Uthinko would have 20 000 shares outstanding. Under Plan 2, Uthinko would have 10 000 shares and $50 000 in debt outstanding. The interest rate is 12% and the tax rate is 30%.a)If EBIT is $10 000, which plan will result in the higher EPS?b)If EBIT is $20 000, which plan will result in the higher EPS?c)What is the breakeven EBIT, ie the indifference point for the 2 plans?QUESTION 2Lynch-Lyons Ltd has decided to finance a $4 million expansion program by issuing either ordinary shares or debentures. Currently the firm has 200 000 ordinary shares outstanding and no long-term debt. Ordinary shares can be sold to net $40 per share. The debenture issue will be a 25-year issue at 12% interest. The tax rate is 30%.a)Assuming that the program will give rise to earnings before interest and taxes (EBIT) of $1.5 million, calculate the expected earnings per share (EPS) for the two (2) alternative financing plans.b)Construct a simple EBIT-EPS graph which would indicate which of the financing plans should be preferred.c)Calculate mathematically the breakeven level of EBIT, ie the indifference point for the two plans.d)Comment on your graph in b) above and your answer to c) above.QUESTION 3Hi Grade Regulator Ltd has currently 3 million ordinary shares outstanding with a market price of $2 per share. It also has $2 million in 6% debentures. The company is considering a $3 million expansion program that it can finance in one (1) of four (4) ways:Plan 1All ordinary shares at $2 per sharePlan 2Debentures at 8% interestPlan 3Preference shares at 7%Plan 4Half ordinary shares at $2 per share and half 8% debenturesa)For a hypothetical level of EBIT of $1 million, calculate the earnings per share (EPS) for each of the alternative methods of financing. Assume a tax rate of 30%.b)Calculate the indifference points between:-Plans 1 and 2-Plans 1 and 4-Plans 2 and 4.c)Interpret your answers in b) above.FIN2101 BUSINESS FINANCE IISOLUTIONS TO TUTORIAL QUESTIONSMODULE 7 - CAPITAL STRUCTUREQUESTION 1a)Plan 1Plan 2Earnings Before Interest &Tax (EBIT)$10 000$10 000Less: Interest Expense 12%06 000Earnings Before Tax10 0004 000Less: Tax 30%3 0001 200Earnings Available for Distribution to Ordinary Shareholders7 0002 800 No. of Ordinary Shares Issued20 00010 000Earnings Per Share (EPS)$0.35$0.28Plan 1 offers the higher EPS.b)Plan 1Plan 2Earnings Before Interest &Tax (EBIT)$20 000$20 000Less: Interest Expense 12%06 000Earnings Before Tax20 00014 000Less: Tax 30%6 0004 200Earnings Available for Distribution to Ordinary Shareholders14 0009 800 No. of Ordinary Shares Issued20 00010 000Earnings Per Share (EPS)$0.70$0.98Plan 2 offers the higher EPS.c)When EBIT = $12 000, EPS is $0.42 under both plans.QUESTION 2a)Share IssueDebenture IssueEarnings Before Interest &Tax (EBIT)$1 500 000$1 500 000Less: Interest Expense 12%0480 000Earnings Before Tax1 500 0001 020 000Less: Tax 30%450 000306 000Earnings Available for Distribution to Ordinary Shareholders1 050 000714 000 No. of Ordinary Shares Issued300 000200 000Earnings Per Share (EPS)$3.50$3.57b) See ATTACHED EBIT-EPS chart.c)d)Assuming that the company wishes to maximise EPS, it would prefer to finance the expansion program by an issue of ordinary shares if the EBIT are likely to be less than $1 440 000. If EBIT are equal to $1 440 000, the company would be indifferent between the equity and debt financing plans. The company would opt for a debenture issue if EBIT are expected to exceed $1 440 000.Given that EBIT are projected to be $1.5 million, I would recommend that Lynch-Lyons Ltd fund the program by issuing debentures.QUESTION 3a)Plan 1Plan 2Plan 3Plan 4EBIT$1 000 000$1 000 000$1 000 000$1 000 000Less: Interest Expense120 000360 000120 000240 000EBT880 000640 000880 000760 000Less: Tax 30%264 000192 000264 000228 000Earnings After Tax616 000448 000616 000532 000Less: Preference Dividends00210 0000Earnings Available for Distribution to Ordinary Shareholders616 000448 000406 000532 000 No. of Ordinary Shares Issued4 500 0003 000 0003 000 0003 750 000EPS13.7 cents14.9 cents13.5 cents14.2 ce