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Financing Alternatives

A company has assets of Rs 1,000,000 financed wholly by equity share capital. There are 100,000 shares outstanding with a book value of Rs 10 per share. Last year’s profit before taxes was Rs 250,000. The tax rate is 35 per cent. The company is thinking of an expansion programme that will cost Rs 500,000. The financial manager considers the three financing plans: (i) selling 50,000 shares at Rs 10 per share, (ii) borrowing Rs 500,000 at an interest rate of 14 per cent, or (iii) selling Rs 500,000 of preference shares with a dividend rate of 14 per cent. The profit before interest and tax are estimated to be Rs 375,000 after expansion.

You are required to calculate: (a) the after-tax rate of return on assets, (b) the earnings per share, and (c) the rate of return on shareholders’ equity for each of the three financing alternatives. Also, suggest which alternative should be accepted by the firm.


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