Question

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: 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. The company may issue common shares at a price of €2.5 per share. 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 Debt Preferred Stock 20% Common Equity 80% 40% 20% 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? (100) 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

" In Financial management Theory of Capital structure or lapital shnchure theory refers to the Systematic approach towards to friencing business activities through a combination of equity and liabality. There are several Several laupeting Capital Structure theories , each of which explores The Relationship between elebt financing equing financing and the market value of the slightly and differently The theories are o alet Income Approach This approach lů Suggested by durend and he was in favour of financial Seeeten leverage deceston h this theory a change in Financial leverage would Cead to a change to the cost of capital @ ouer operating income approach in This approach states that the weighted average lost of capital remains Constant .pf belenen in the fact that marleet analysis a from as a whole and discout at a particular rate, which has

no relation to elebt equity ratio Traditional Approach - This approach does not define hard and fast facts Il says that Cost of Capital is a function of Capital strachure The Special thing about this approach is that if belione in optimum Capital struchire implies that at a perbicular Role of clebt and equity Mopic LINNI A MILLGK APPROACH It says that the capital struchire is irrelement to the value of a firm . The value of a identical firms would remain the same and the value would not effected by the choice of finance adopted to finance the assets, value of the king tiem es dependent on the expected fachine earnings. Is when there are totax no tosces, Scanned with CamScanner

Dory 1000,000 80 Plan A I Plan B Plan C. Almond allocated 5000,000 soogoooo 5000 000 20% 1 40% Debt Percentage | 50% Debt amont 1000,000 1000,000 2500,000 Preference Shore porcentage Preference Stock amount 1500000 Camon Shores percentage .40% 20% Common sens Shores Value 4000,000 1000000 | 1000,000, Anvel GBIT 600,000 600,000 1600,000 I less intrest @ 8% on Debt . (80000)|(160000) (400,000.) «С Т 520000 | 440000 loss garc @ 2017 (104000)|(88000) |(80000) Earnings after tone 416000 | 352000 320000 less preference oliwelamt oloy o |(100,000 150000) Begruing s ovilable to share holdies 416000 252000 10000 @noof Show leelor's Shanes 1600,000 800,000 400,000 GPS = q cominge per share? If Only 1€ 0.315€ 0.495 As for the obow daha plane is beneficial to the Company as it provide high earnings per shore. 400000

Debt financing A equity financing Benefit of equity financing i I Benefit of debt financing GBIT-EPS - EBIT inclifference point a when EBIT reaches the GBIT- Gps indifference poin't both trancing plans generchi equal GPS in the given plass so the right mise of Debt and equity gives better Cepidl structure in the given problem plan c has higher leverage brause because of high debt usage bato beat it provides higher EPS which is beneficial to the shareholders. Scanned with CamScanner