Question

'Viyo Ltd.' is a company manufacturing textiles. It has a share capital of Rs $60$ lakhs. The earning per share in the previous year was $Rs.0.50$. For diversification, She company requires additional capital of $Rs.40$ lakhs. The company raised funds by issuing $10\%$ debentures for the same. During the current year the company earned profit of Rs $8$ lakhs on capital employed. It paid tax @ $40\%$.
(a) Slate whether the shareholders gained or lost, in respect of earning per share on diversification. Show you 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 $=Rs.8,00,000$ (Given)
Interest on $10\%$ debentures $=Rs.4,00,000(40,00,000\times \frac{10}{100})$
Profit before Tax $=$ Profit before Interest and Tax-Interest
$=8,00,000-4,00,000=Rs.4,00,000$
Tax @ $40\%=Rs.1,60,000(40,00,000\times \frac{10}{100})$
Profit after Tax $=$ Profit before Tax $-$ Tax
$=4,00,000-1,60,000=Rs.2,40,00$
$EPS=\frac{Profitaftertax}{NumberofEquityShares}=\frac{2,40,000}{6,00,000}=0.4$
Note:The face value of equity shares is assumed to be $Rs.10$ each. Hence, number of equity shares is $6,00,000$.
(b) The three factors that favour the issue of debentures by the company as part of it's capital structure are given below.
1. Tax deduct/bay 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. Haydn management. In the given scenario, the company already has a share capital of $Rs.60,00,000$. 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 noes For a company, cost of raising capital through debentures is relatively lower than that through equity. This is due to assurance (of rate of returns) and guaranteed repayment (of debenture amount at maturity) that debenture holders require lower rate of returns. Besides this, interest amount payable to debenture holders is 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 prefer to opt for debentures, as higher use of debt, lowers the over-all cost of capital with cost of equity remaining unaffected.