Problems in EBIT – EPS Analysis

1.Twister Limited offers you the following data:

    Rupees  Sales 16,00,000  Variable Costs 75% of Sales  Contribution 25% of Sales  Fixed Costs 2,00,000  Loans 2,00,000

  Share Capital Rs 1,00,000 of

Rs.10 each  Reserves 1,00,000  Interest 10% on Loans  Taxes 40% on PBT

Compute: Operating Leverage, Financial Leverage, Combined Leverage, EBIT and EPS.

2.Skyline software Ltd has appointed you as its finance manager. The company wants to implement a project for which Rs 30 lakh is required to be raised from the market as a means of financing the project. The following financing plans and options are at hand. (Numbers is thousand)

Particulars Plan A Plan B Plan COption 1 Equity shares 30 30 30

Option 2 Equity shares 15 20 10 12 % pre shares - 10 10 10 % non Con debt 15 nil 10

Assuming corporate tax to be 35 % and the face value of all shares and debentures to be Rs 100 each, calculate the indifference points and earnings per share for each of the financing plans. Which plan should be accepted by the company?

3. A company has the choice of issuing 10 % debentures or Rs 100 equity shares to raise Rs 20 lakhs to meet its long term investment requirements. Its capital structure consists of 20,000 ordinary shares of Rs 100 each and 8 % debentures of Rs 10, 00, 000 and 12 % preference shares of Rs 10,00,000.

Determine the level of EBIT at which EPS would be the same whether the new funds are acquired by issuing ordinary shares or by issuing 10 % debentures.

4.Mr Gupta is an entrepreneur and has recently set up manufacturing unit of pens. He currently sells 1 million pens a year at Rs 5 each. His variable cost to produce the pen is Rs 3 per pen and he has Rs 5 lakh in fixed costs. His sales to assets ratio is 5 times and 40 percent of his assets are financed with 8 % debt, with the balance being financed by ordinary shares of Rs 10 per share. The tax rate is 35 percent.

Mr. Gupta’s newly appointed Finance Manager, Mr. Rohit feels that Gupta is doing it all wrong. By reducing his price to Rs 4.50 per pen, he could increase his debt to assets ratio to 50 percent, with the balance in shares. It is assumed that the interest rate would go up 1 percent and that the price of shares would remain constant.

a) Compute the EPS under Gupta and Rohit plans. Is Mr. Rohit’s perception right?

b) Mr Gupta’s partner does not think that fixed costs would remain constant under Rohit’s plan but they would go up 10 percent. If this is the case, should Mr Gupta shift to Rohit’s plan, based on earnings per share

5. The selected financial data for A,B and C companies for the current year ended March 31 are as follows.

Particulars A B CVariable expenses as % of sales 66.67 75 50Interest expenses (Rs) 200 300 1,000Degree of operating leverage 5 6 2Degree of financial leverage 3 4 2Income tax 0.35 0.35 0.35

Prepare income statement for A, B and C companies in the following format

Particulars A B C

Sales xxxx xxxx xxxxx

Less variable cost xxxx xxxx xxxxxLess Fixed cost xxxx xxxx xxxxx

EBIT xxxx xxxx xxxxx

Less interest xxxx xxxx xxxxEarnings before tax xxxx xxxx xxxx

Less tax xxxx xxxx xxxxEAT (Net income) xxxx xxxx xxxx

Prepare income statement for A, B and C companies in the following format

Particulars A B C

Sales 4,500 9,600 24,000

Less variable cost 3,000 7,200 12,000Less Fixed cost 1,200 2,000 10,000

EBIT 300 400 2,000

Less interest 200 300 1,000Earnings before tax 100 100 1,000

Less tax 35 35 350 EAT (Net income) 65 65 650

6. X Ltd needs Rs 10 lakh for expansion. The expansion is expected to yield an annual EBIT of Rs 1,60,000. In choosing a financial plan, X Ltd has an objective of maximizing earnings per share. It is considering the possibility of issuing equity shares and raising debt of Rs 1,00,000 or Rs 4,00,000 or Rs 6,00,000. The current market price per share is Rs 25 and is expected to drop to Rs 20 if the funds are borrowed in excess of Rs 5,00,000.

Funds can be borrowed at the rates indicated below.a. Up to 1,00,000 @ 8 %b. Over Rs 1,00,000 and up to Rs 5,00,000 @ 12 %c. Over Rs 5,00,000 @ 18 %

Assuming a tax rate of 50 %. Determine the EPS for the three financing alternatives.

Solution

Particulars Plan 1 Plan 2 Plan 3EBIT 1,60,000 1,60,000 1,60,000Interest 8,000 44,000 74,000 PBT 1,52,000 1,16,000 86,000Tax at 50 % 76,000 58,000 43,000 PAT 76,000 58,000 43,000

No of shares 36,000 24,000 20,000EPS 2.11 2.42 2.15

7. XYZ Ltd wishes to raise Rs 1,000,000 to finance the acquisition of new assets. It is considering three alternative ways of financing assets.

Plan 1: to issue only equity shares at Rs 20 per sharePlan 2: to borrow Rs 500,000 at 14 percent rate of interest and issue

Equity shares at Rs 20 per share for the balance Plan 3: to borrow Rs 750,000 at 14 percent rate of interest and issue

Equity shares at Rs 20 per share for the balance.

The following are the estimates of the earnings from the assets with probability distribution:

EBIT (Rs) Probabilities

80,000 0.10120,000 0.20160,000 0.40200,000 0.20320,000 0.10

You are required to calculate the Earnings Per Share and determine the financial risk for each of the three alternatives. Assume a tax rate of 35 percent.