Question

Subject 3 (30%) Orion is a small company listed in the stock market that until now is funded exclusively by common equity. You recently had a meeting with the financial director where you discussed the possibility of using other financing sources than common equity. He then invited you to take some time and work on this case, Orion's data is as follows: 1. The total value of the company today is €5,000,000. 2. The company may obtain long-term loans at the rate of 8%. 3. The company may issue preferred shares with a compulsory dividend of 10% of their value 4. The company may issue common shares at a price of €2.5 per share. 5. The company's annual earnings before interest and taxes are expected to be €600,000 6. The corporate tax rate is 20%. You have thought of presenting the following three possible financing plans (according to which €5,000,000 are allocated): Plans Preferred Stock Debt 20% 40% 50% 20% 30% Common Equity 80% 40% 20% Answer the following questions. a. You would like to make a brief introduction to the theory of capital structure and present it to the financial manager. Briefly refer to the various theories mentioned in this field (approximately 500 words). (10%) b. Calculate the earnings per share (EPS) that correspond to each of the three (3) plans. Which of the three alternative plans would you suggest according to the data available to you, using the EBIT-EPS analysis to support your answer? (10%) c. Diagrammatically investigate the relationship between Earnings before interest and taxes (EBIT) and Earnings per Share (EPS) for the three alternative plans and comment on the conclusions drawn from the chart. Discuss which plan is preferable at the different EBIT levels? (10%)

Answer 1

		Theory of Pecking Order
		As per this theory, companys will prefer to fund growth by internal finance first
		If any external finance is require it will prefer debt
		The last preference will be external equity
		Theory of Pecking Order, is based on Asymmetry of information assumption
		Management has higher information regarding prospect of the company
		The Trade Off Theory of Capital Structure
		Companys make a trade off between debt and Equity in deciding Capital structure
		The Debt has lower cost , but as Debt portion goes up risk also goes up
		As Debt /Equity goes up, Present Value of tax shield goes up
		But, simulteneously, the present value of Bankruptcy cost also goes up
		This results in Debt/Equity trade off with optimum capital structure
	b	Earning Per Share -PLAN A
	A	Debt =20%*5000000	€         1,000,000
	B	Preferred Shares	0
	C	Equity	€         4,000,000	(5000000-1000000)
	D	Number of Shares	1,600,000	(4000000/2.5)
	E	Earning Before interest and taxes(EBIT)	€             600,000	€      540,000	€      480,000	€      420,000	€      660,000
	F=A*8%	Interest Cost on debt	€               80,000	€         80,000	€         80,000	€         80,000	€         80,000
	G=E-F	Earning after interest and before taxes	€             520,000	€      460,000	€      400,000	€      340,000	€      580,000
	H=G*20%	Taxes	€             104,000	€         92,000	€         80,000	€         68,000	€      116,000
	I=G-H	Net Income	€             416,000	€      368,000	€      320,000	€      272,000	€      464,000
	J=B*10%	Preferred dividend	0	0	0	0	0
	K=I-J	Earning available to Common Shareholders	€             416,000	€      368,000	€      320,000	€      272,000	€      464,000
	L=K/D	Earning Per Share -PLAN A (EPS)	€                    0.26	€             0.23	€             0.20	€             0.17	€             0.29
	b	Earning Per Share -PLAN B
	A	Debt =40%*5000000	€         2,000,000
	B	Preferred Shares=20%*5000000	1000000
	C	Equity=40%*5000000	€         2,000,000
	D	Number of Shares	800,000	(2000000/2.5)
	E	Earning Before interest and taxes(EBIT)	€             600,000	€      540,000	€      480,000	€      420,000	€      660,000
	F=A*8%	Interest Cost on debt	€             160,000	€      160,000	€      160,000	€      160,000	€      160,000
	G=E-F	Earning after interest and before taxes	€             440,000	€      380,000	€      320,000	€      260,000	€      500,000
	H=G*20%	Taxes	€               88,000	€         76,000	€         64,000	€         52,000	€      100,000
	I=G-H	Net Income	€             352,000	€      304,000	€      256,000	€      208,000	€      400,000
	J=B*10%	Preferred dividend	€             100,000	€      100,000	€      100,000	€      100,000	€      100,000
	K=I-J	Earning available to Common Shareholders	€             252,000	€      204,000	€      156,000	€      108,000	€      300,000
	L=K/D	Earning Per Share -PLAN B (EPS)	€                    0.32	€             0.26	€             0.20	€             0.14	€             0.38
	b	Earning Per Share -PLAN C
	A	Debt =50%*5000000	€         2,500,000
	B	Preferred Shares=30%*5000000	€         1,500,000
	C	Equity=20%*5000000	€         1,000,000
	D	Number of Shares	400,000	(1000000/2.5)
	E	Earning Before interest and taxes(EBIT)	€             600,000	€      540,000	€      480,000	€      420,000	€      660,000
	F=A*8%	Interest Cost on debt	€             200,000	€      200,000	€      200,000	€      200,000	€      200,000
	G=E-F	Earning after interest and before taxes	€             400,000	€      340,000	€      280,000	€      220,000	€      460,000
	H=G*20%	Taxes	€               80,000	€         68,000	€         56,000	€         44,000	€         92,000
	I=G-H	Net Income	€             320,000	€      272,000	€      224,000	€      176,000	€      368,000
	J=B*10%	Preferred dividend	€             150,000	€      150,000	€      150,000	€      150,000	€      150,000
	K=I-J	Earning available to Common Shareholders	€             170,000	€      122,000	€         74,000	€         26,000	€      218,000
	L=K/D	Earning Per Share -PLAN C (EPS)	€                    0.43	€             0.31	€             0.19	€             0.07	€             0.55
		PLAN C is preferred , because it gives highest EPS
										PLANC is preferred, because it gives highest EPS EBIT € 420,000 480,000 540,000 600,000 660,000 EPS PLANA EPS PLAN B EPS PLANC € 0.17 € 0.14 € 0.07 € 0.2000 € 0.195 € 0.19 € 0.23 € 0.26 € 0.31 € 0.32 € 0.32 € 0.43 € 0.38 € 0.38 € 0.55 € Preferred Plan at different EBIT Levels EBIT Preferred Plan EPS 420,000 PLANA € 480,000 PLANA € 540,000 PLANC € 600,000 PLANC € 660,000 PLANC € 0.17 0.2000 0.31 0.43 0.55 EPS AT DIFFERENT LEVEL OF EBIT €0.60 € 0.50 € 0.40 €0.30 €0.20 €0.10 € 100,000 € 200,000 € 300,000 € 400,000 €500,000 € 600,000 € 700,000 +EPS PLANA ---EPS PLAN B -- EPS PLANC 055