Capital Structurs Decisions

Topics: Corporate finance, Debt, Preferred stock Pages: 5 (880 words) Published: July 13, 2013
CAPITAL STRUCTURE DECISIONS

When a firm is seeking financing for a project it is usually a choice between additional debt financing or an additional equity issue, assuming internally generated funds are not sufficient.

The chosen option of financing can make a difference to EPS (earnings per share ), which is an important investment analyst ratio.

Example :
Assume Cherokee Tire Co’s long term capitalization of $18 mill is as follows :

Debt$5 mill @ 9 per cent.
Shareholders Equity $13 mill.

The company wishes to raise $5 mill for expansion. It has 3 options ;

i.Issue 100,000 new common stock @ $50.00 each
ii.Issue new debt @ 8%
iii.Issue preferred stock with a 7.6 % dividend.

Present EBIT are $3 mill, and corp. tax rate is 40%
There are 400,000 shares of common stock presently outstanding.

Suppose EBIT is expected to move to $4 mill after expansion, what would EPS be under each financing option.

Common Stock Debt Pref. Stock
$ $ $

Estimated EBIT 4,000,000 4,000,000 4,000,000 Interest on existing debt 450,000 450,000 450,000 New debt interest ---- 400,000 ………. Earnings before taxes 3,550,000 3,150,000 3,550,000 Taxes @ 40% 1,420,000 1,260,000 1,420,000 After tax earnings 2,130,000 1,890,000 2,130,000 Preferred dividend 380,000 ------------------------- ------------ Earnings available to common

stockholders 2,130,000 1,890,000 1,750,000

Number of shares 500,000 400,000 400,000 Earnings per share ( EPS ) $4.26 $4.73 $4.38

Earnings available to common stockholder is higher under debt than preference shares because of the debt tax shield, even though the cost of debt ( before tax ) is higher than the cost of Pref. Shares. Also EPS is highest under debt.

However, what is the indifference point for financial leverage ? That is, the level of EBIT below which financing with a common stock alternative will provide higher earnings per share.

Mathematical solution :

EBIT* - C1 = EBIT* - C2
S1 S2
Where EBIT* = the EBIT indifference point between the two methods of financing. C1 and C2 = the annual interest expense or preferred stock dividends on a before tax basis for methods 1 and 2 .

S1and S2 = the number of shares of common stock after financing methods 1 and 2

EBIT* - 450,000 = EBIT* - 850,000 500,000 400,000

( EBIT* )( 400,000) – ( 450,000)( 400,000) = ( EBIT*)( 500,000) – (850,000)( 500,000)

100,000 EBIT* = 245,000,000,000 EBIT * = $2,450,000
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