Question

Sakshi Ltd. is a company manufacturing electronic goods. It has a share capital of Rs. 120 lakhs. The earning per share in the previous years was Rs 0.5. For diversification, the company requires additional capital of Rs 80 lakhs. The company raised funds by issuing 10% debentures for the same. During the current year, the company earned a profit of Rs. 16 lakhs on capital employed. It paid a tax of 40 $\%$.

(a) State whether the shareholders gained or lost in respect of earning per share on diversification. Show your calculations clearly.

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

Answer 1

(a) Profit before Interest & Tax = Rs 16,00,000 (Given)

Interest on 10$\%$ debentures = Rs 8,00,000 $(80,00,000\times \frac{10}{100})$

Profit before Tax = Profit before Interest & Tax - Interest = 16,00,000-8,00,000 = Rs 8,00,000

Tax $@40\%(8,00,000\times \frac{40}{100})$

Profit after Tax = Profit before Tax - Tax = 8,00,000 - 3,20,000 = Rs 4,80,000

$\text{EPS}=\frac{\text{Profit after Tax}}{\text{Number of Equity Shares}}=\frac{4,80,000}{12,00,000}=0.4$

Note: The face value of equity shares is assumed to be Rs. 10 each. Hence, number of equity shares is 12,00,000.

(b) The three factors that favour the issue of debentures by the company as part of its capital structure are given below:

1. Tax deductibility: Interest paid by the company to its debentures is tax deductible. In the above scenario, the company is paying tax @ 40%. Thus, it is beneficial for the company to issue debentures.

2. Control over management: Issuing more shares will dilute the control of management. Thus, companies that are apprehensive of the dilution of control opt for more of debt and less of equity.

3. Relatively low cost: For a company, the cost of raising capital through debentures is relatively lower than that through equity. This is due to assurance (of the rate of returns) and guaranteed repayment (of debenture amount at maturity) that debenture holders require a lower rate of returns. Besides this, the interest amount payable to debenture holders is a deductible expense. This is to say that interest amount is deducted from the company's earnings and then the net amount is used for calculation of tax liabilities. Hence, companies opt for debentures, as higher use of debt lowers the overall cost of capital with the cost of equity remaining unaffected.