Question

Kay Ltd is a company manufacturing textiles. It has a share capital of Rs. 60 lakhs. In the previous year, the earning per share was Rs. 0.50. For diversification, the company requires additional capital of Rs. 40 lakhs. The company raised funds by issuing 10% debentures. During the year the company earned a profit of Rs. 8 lakhs on the capital employed. It paid tax @ 40%.

(i) State whether the shareholders gained or lost, concerning earning per share on diversification. Show your calculations clearly.

(ii) Also, state any three factors that favour the issue of debentures by the company as part of its capital structure.

Answer 1

$\begin{array}{cc}\text{Profit before interest and tax}& Rs.8,00,000\\ \text{(-) Debentures interest}& Rs.4,00,000\\ (40,00,000\times \frac{10}{100})& \\ \text{Profit after interest}& Rs.4,00,000\\ \text{(-) Tax}& Rs.1,60,000\\ \text{Profit after tax}& Rs.2,40,000\\ \text{Earning per share}& \frac{\text{Profit After Tax}}{\text{Number of Shares}}=\frac{2,40,000}{6,00,000}\\ & =0.40\end{array}$

Since earning per share has fallen from 0.50 to 0.40, the shareholders stand to lose on diversification.
Note: Shares are assumed to be of Rs. 10 each.
So, $\text{number of shares}=\frac{Sharecapital}{Facevaluepershare}$
$=\frac{60,00,000}{10}=6,00,000$ shares

(ii) Three factors that favour issue of debentures by the company as part of its capital structure are:
(a) Debenture interest payable is a charge to the profits. Hence a company stands to gain in terms of tax-benefits.
(b) Issue of debentures helps the shareholders of the company gain through 'Trading on Equity'.
(c) Debenture is a cheaper source of finance as compared to equity.