After yesterday prime s board meeting, Agri Limited agreed to change its capital
ID: 2734190 • Letter: A
Question
After yesterday prime s board meeting, Agri Limited agreed to change its capital structure. The current capital structure of Agri is based on the view that low or no debt is better than high levels of debt. Agri Limited currently has a $200, 000 long-term bank loan paying 9% interest. It also has 80, 000 ordinary shares on issue under the current structure. The proposed capital structure will double the amount of the current bank loan, but Agri will need to pay 10% interest. With this change, the number of ordinary shares on issue would reduce to 40, 000 shares. Agri operates in the agricultural industry and the proposed capital structure is based on the industry averages. Assuming Agri pays 30% tax on its income, calculate the following: Assuming the firm expects EBIT of 3100, 000, what are the EPS for the current and proposed capital structures? Explain whether or not the board has made the right decision and justify your answer. Calculate the EBIT/EPS indifference point for EBIT. Indicate over which range of EBIT each capital structure is preferred. State two shortcomings of EBIT/EPS analysis.Explanation / Answer
Answer:A
Yes. Board made the right decision because due to this earning per share is increased.
Answer:B EBIT-EPS indifference point
Current=Proposed
(EBIT-18000)*(1-0.30)/80000 =(EBIT-40000)*(1-0.30)/40000
(0.70 EBIT-12600)/80000=(0.70 EBIT-28000)/40000
40000*(0.70 EBIT-12600)=80000*(0.70 EBIT-28000)
28000 EBIT-5040,00000=56000 EBIT-2240000000
EBIT=62000
Answer:C If EBIT is expected to be below $62,000, current capital structure is preferred. If EBIT is expected to be above $62,000 Proposed capital structure is preferred.
Answer:D An EPS/EBIT analysis is the most widely used technique for determining whether debt,stock, or a combination of debt and stock is the best alternative for raising capital to implement strategies.
Several considerations should be made whenever using this technique.Profit levels may be higher for stock or debt alternatives when EPS levels are lower.Control is also a concern. When additional stock is issued to finance strategy implementation,ownership and control of the enterprise are diluted.
When using EPS/EBIT analysis, timing inrelation to movements of stock prices, interest rates, and bond prices becomes important.
Particulars Current capital structure Proposed capital structure EBIT 100000 100000 Less: interest 18000 40000 EBT 82000 60000 Less: tax @30% 24600 18000 EAT 57400 42000 No of shares outstanding 80000 40000 EPS 0.7175 1.05