Question

A common problem facing any business entity is the debt versus equity decision. When funds are required to obtain assets, should debt or equity financing be used? This decision is also faced when a company is initially formed. What will be the mix of debt versus equity in the initial capital structure? The characteristics of debt are very different from those of as are the financial products. Their initial capitalization goal is Kshs. 50 million. That is, the incorporators have decided to raise Kshs. 50 million to acquire the initial operating assets of the company. They have narrowed down the financing mix alternatives to two:

1. All equity financing
2. Kshs. 20 million in debt financing and Kshs. 30 million in equity financing.

No matter which financing alternative is chosen, the company expects to be able to generate a 10% annual return, before payment of interest and income taxes, on the Kshs. 50 million in assets acquired. The interest rate of debt would be 8%. The effective income tax rate will be approximately 30%.

Alternative 2 will require specified interest and principal payments to be made to the creditors at specific dates. The interest portion of these payments (interest expense) will reduce the taxable income of the company and hence the amount of income tax the company will pay. The all-equity alternative requires not specified payments to be made to suppliers of capital. The company is not legally liable to make distributions to its owners. If the board of directors does decide to make a distribution, it is not an expense of the company and does not reduce taxable income and hence the taxes the company pays.

Required:

1. Prepare abbreviated income statements that compare first year profitability for each of the two alternatives.                                                                                               (10 marks)

Answer 1

Solution) Since the company expects to be able to generate a 10% annual return, before payment of interest and income taxes, on the Kshs. 50 million in assets acquired.

Hence, Earnings before Interest and Income Taxes = 10%*50 million

= 5 million

Alternative 1: All equity financing, hence, no interest payments

Tax expense = Tax rate*Earnings before taxes

The income statement is shown below:

Earnings before Interest and Income Taxes	5
Interest on debt	0
Earnings before taxes	5
Tax expense (@30%)	1.5
Net Income	3.5

Alternative 2: Kshs. 20 million in debt financing and Kshs. 30 million in equity financing.

Interest on debt = Interest rate*Debt amount

= 8%*20 million

= 1.6 million

The income statement is shown below:

Earnings before Interest and Income Taxes	5
Interest on debt	1.6
Earnings before taxes	3.4
Tax expense (@30%)	1.02
Net Income	2.38

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