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Tax Shield Education Centre Cost Of Capital And Capital Structure Capital of a company consists of : 1. Equity ( equity share capital + reserves & surpluses ) 2. Preference share capital 3. Loan capital i.e. Debenture

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EBIT-EPS Chart Falcon Limited plans to raise additional capital of Rs. 10 mln for financing an expansion project. In this context, it is evaluating two alternative financing plans: (i) issue of equity shares (1 mln equity shares at Rs. 10 per share), and (ii) issue of debentures carrying 14 per cent interest. What will be the EPS under the two alternative financing plans for two levels of EBIT, say Rs. 4 mln and Rs. 2 mln? Following table shows the value of EPS for these two levels of EBIT under the alternative financing plans.

Equity Financing 4,000,000 Interest Profit before taxes Taxes Profit after tax Number of equity sharesCalculate the indiference EBIT. In general, the relationship between EBIT and EPS is as follows :

Debt Financing EBIT: 1,400,000 2,600,000 1,300,000 1,300,000 1,000,000

EBIT: 2,000,000 EBIT: 4,000,000 EBIT: 2,000,000 2,000,000 1,000,000 1,000,000 2,000,000 4,000,000 2,000,000 2,000,000 2,000,000 1,400,000 600,000 300,000 300,000 1,000,000

(EBIT - I) (1 t) EPS = n The EBIT inifference point between two alternative plans can be obtained mathemetecally by solving the following equation ( EBIT I1 ) ( 1 t ) = ( EBIT I2 ) ( 1 t ) n1 n2 were EPS = EBIT = I = t = n = earnings per share earnings before interest and taxes interest burden tax rate number of equity shares

where

EBIT* = indifference point between the two alternative financing plans I1, I2 = interest expenses before taxes under financing plans 1 and 2 t = income-tax rate n1, n2 = number of equity shares outstanding after adopting financing plans 1 and 2.

Risk Considerations

Tax Shield Education Centre

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So far we looked at the impact of alternative financing plans on EPS. What is the effect of leverage on risk? A precise answer to this question is not possible with the help of EBIT-EPS analysis. However, a broad indication may be obtained with reference to it. The finance manager may do two things : (i) compare the expected value of EBIT with its indifference value, and (ii) assess the probability of EBIT falling below its indifference value. If the most likely value of EBIT exceeds the indifference value of EBIT, the debt financing option, prima facie, may be advantageous. The larger the difference between the expected value of EBIT and its indifference value, the stronger the case for debt financing, other things being equal. Given the variability of EBIT, arising out of the business risk of the company, the probability of EBIT falling below the indifference level of EBIT may be assessed. If such probability is negligible, the debt financing option is advantageous. On the other hand, if such probability is high, the debt financing alternative is risky. The notion may be illustrated graphically as shown in where two probability distributions of EBIT (A and B) are superimposed on the EBIT-EPS chart. Distribution A is relatively safe, as there is hardly any probability that EBIT will fall below its indifference level. With such a distribution, the debt alternative appears to be advantageous. Distribution B, on the other hand, is clearly risky because there is a significant probability that EBIT will decline below its indifference value. In this case, the debt alternative may not be regarded as desirable. ROI-ROE ANALYSIS In the preceding section we looked at the relationship between EBIT and EPS under alternative financing plans. Pursuing a similar line of analysis, we may look at the relationship between the return on investment (ROI) and the return on equity (ROE) for different levels of financing leverage. Suppose a firm, Korex Limited, which requires an investment outlay of Rs. 100 mln, is considering two capital structures. Equity Debt Capital Structure A 100 0 Equity Debt Capital Structure B 50 50

While the average cost of debt is fixed at 12 per cent, the ROI (defined as EBIT divided by total assets) may vary widely. The tax rate of the firm is 50 per cent. Based on the above information, the relationship between ROI and ROE (defined as equity earnings divided by net worth) under the two capital structures, A and B, would be as shown in Table 13.2. Graphically the relationship is shown as below ROE B A

ROI

Tax Shield Education Centre Looking at the relationship between ROI and ROE it is observed that :

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1.The ROE under capital structure A is higher than the ROE under capital structure B when ROI is less than the cost of debt. 2.The ROE under the two capital structures is the same when ROI is equal to the cost of debt. Hence the indifference (or breakeven) value of ROI is equal to the cost of debt. 3.The ROE under capital structure B is higher than the ROE under capital structure A when ROI is more than the cost of debt. Mathematical Relationship The influence of ROI and financial leverage on ROE is mathematically as follows : Where ROE ROI r D/E t ROE = [ROI + (ROI r) D/E] (1 t) = return on equity = return on investment =cost of debt = debt-equity ratio = tax rate

ASSESMENT OF DEBT CAPACITY Employment of debt capital entails two kind of burden: interest payment and principal repayment. To assess a firms debt capacity we look at its ability to meet these committed payments. This may be judged in terms of: Coverage ratios Probability of cash insolvency Inventory of resources

Coverage Ratios A coverage ratio shows the relationship between a committed payment and the source for that payment. The coverage ratios commonly used are: interest coverage ratio, cash flow coverage ratio, and debt service coverage ratio. This may be derived as follows: PAT ROE = E (EBIT I) (1 t) ROE = E (TA ROI I) (1 t) ROE = E [(E + D) ROI rD] (1 t) ROE = E ROE = [ROI + (ROI r) D/E] (1 t) Interest Coverage Ratio : The interest coverage ratio (also referred to as the times interest earned ratio) is simply defined as:

Tax Shield Education Centre Earnings before interest and taxes Interest on debt

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To illustrate, suppose the most recent earnings before interest and taxes (EBIT) for Vitrex Company were Rs. 120 million and the interest burden on all debt obligations were Rs. 20 million. The interest coverage ratio, therefore, would be 120/20 = 6. What does it imply? It means that even if EBIT drops by 83 1/3 percent, the earnings of Vitrex Company cover its interest payment. Though somewhat commonly used, the interest coverage ratio has several deficiencies: (i) It concerns itself only with the interest burden, ignoring the principal repayment obligation. (ii) It is based on a measure of earnings, not a measure of cash flow. (iii) It is difficult to establish a norm for this ratio. How can we say that an interest coverage ratio of 2,3,4, or any other is adequate? Cash Flow Coverage Ratio This may be defined as: EBIT + Depreciation + Other non-cash charges Loan repayment installment Interest on debt + -(1 Tax rate) To illustrate, consider a firm : Depreciation EBIT Interest on debt Tax rate Loan repayment installment Calculate the cash flow coverage ratio for this firm . Debt Service Coverage Ratio Financial institutions which provide the bulk of long-term debt finance judge the debt capacity of a firm in terms of its debt service coverage ratio. This is defined as: PATi + DEPi + INTi DSCR = t INTi + LRIin

Rs. 20 mln Rs. 120 mln Rs. 20 mln 50% Rs. 20 mln

n

where

DSCR PATi DEPi INTi LRIi n

= debt service coverage ratio = profit after tax for year I = depreciation for year I = interest on long-term loan for year I = loan repayment instalment for year I = period of loan

In determination of best capital structure , share- holder prefers higher E.P.S. ( i.e. earning per share ) or EPS volatility EPS volatility refers to the magnitude or the extent of fluctuation of earnings per share of a company in various years as compared to the mean or average earnings per share. In other words, EPS volatility shows whether a company enjoys a stable income or not. It is obvious that higher the EPS volatility, greater would be the risk attached to the company. A major cause of EPS volatility would be the fluctuations in the sales volume and the operating levarage. It is obvious that the net profits of a company would greatly fluctuate with small fluctuations in the sales figures specially if the fixed cost content is very high. Hence, EPS will fluctuate in such a situation. This effect may be heightened by the financial leverage. E.P.S. = Profits available to equity. Share holders number of equity shares = Earning per share or EPS = [ (PBIT - I ) (1-t) - Pref Dividend ] No. of Equity Share.

Tax Shield Education Centre Where, PBIT = Profit before tax. ; I = Interest.; t = Tax rate of the firm. At point of Indifference : (EPS)1 = (EPS ) 2

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SEBI Guidelines Uptil early 1992, matters like a companys capital structure, its pricing of capital issues, dividend and interest rates, capitalisation ofeach Elementswere governed by the Capital Calculation of costs for reserves, etc. issues (Control) Act, 1947. The system had certain drawbacks like the under pricing of equity issues, delays in getting clearances, etc. So the Act was abolished and companies are now required to conform to the disclosure and investor protection guidelines issued by the Securities and Exchange Board of India (SEBI). The important guidelines are :1. A new company set up by existing companies with a five-year track record of consistent profitability can freely price its capital issues, provided the promoting companies participation is at least 50 percent. Other new companies must price t