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Question
Sakshi Ltd. is a company manufacturing electronic goods. It has a share capital ofRs 120 lakhs. The earning per share in the previous year wasRs 0.5. For diversification, the company requires additional capital ofRs 80 lakhs. The company raised funds by issuing 10% debentures for the same. During the current year the company earned profit ofRs 16 lakhs on capital employed. It paid tax @ 40%.
a. State whether the shareholders gained or lost in respect of earning per share on diversification. Show your calculations clearly.
b. Also state any three factors that favour the issue of debentures by the company as part of its capital structure.
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Solution
a. Let the face value of equity share be Rs 10 each.
Profit before Interest & Tax = Rs 16,00,000
Interest on 10% debentures = Rs 8,00,000
Profit before Tax= Profit before Interest and Tax-Interest
Profit before Tax= 16,00,000 - 8,00,000 = Rs 8,00,000
Tax @ 40%`=8,00,000xx40/100=Rs 3,20,000`
Profit available to shareholders = 8,00,000 - 3,20,000 = Rs 4,80,000
Earning Per Share(EPS)`=`
Thus, shareholders have incurred loss after the issue of debentures as Earning Per Share (EPS) has fallen from Rs 0.5 to Rs 0.4.
b. The following are the three factors that favour the issue of debentures by the company as part of its capital structure.
i. Good Cash Flow Position: If the company is having a good cash flow position, then issuing debentures is more favourable as compared to issue of shares.
ii. High Tax Rate: It is beneficial for the company to issue debentures if the tax rate is higher. This is because interest paid by the company to its debenture holders is tax deductible.
iii. Control: If the company does not want to dilute the control of management, then issuing debentures is the best for the company.
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