ABC Corp Ltd has 10 million shares and $600,000 of debt (issues bonds @ 7% p.a.). EBIT is projected to be $3 million. The company tax rate is 20%.Preference shares pay an annual dividend of $100,000. Management is considering two options for capital restructure:
Option 1: The Company would borrow $3.5 million at 8% interest rate and use the proceeds to engage in share repurchase program for 3.5 million shares at the current market price of $1.
Option 2: Company can raise $3.5 million by issuing new shares at the current market price of $1.
Required:
a) What is the current EPS for shareholders? (5 marks)
b) What will be the EPS after the change in capital structure under option 1 and option 2? Hint: show full working from EBIT to Net Profit (12 marks)
c) Does it make sense for management to go ahead with either of the capital restructure options? If yes, which of the two options is EPS accretive? (2 marks)
d) What is meant by the term ‘capital structure’ and what circumstances with respect to Weighted Cost of Capital (WACC) and the value of the firm define an optimal capital structure? (6 marks)
ABC Corp Ltd has 10 million shares and $600,000 of debt (issues bonds @ 7% p.a.). EBIT is projected to be $3 million. The company tax rate is 20%.Preference shares pay an annual dividend of $100,000. Management is considering two options for capital restructure:
Option 1: The Company would borrow $3.5 million at 8% interest rate and use the proceeds to engage in share repurchase program for 3.5 million shares at the current market price of $1.
Option 2: Company can raise $3.5 million by issuing new shares at the current market price of $1.
Required:
a) What is the current EPS for shareholders? (5 marks)
b) What will be the EPS after the change in capital structure under option 1 and option 2? Hint: show full working from EBIT to Net Profit (12 marks)
c) Does it make sense for management to go ahead with either of the capital restructure options? If yes, which of the two options is EPS accretive? (2 marks)
d) What is meant by the term ‘capital structure’ and what circumstances with respect to Weighted Cost of Capital (WACC) and the value of the firm define an optimal capital structure? (6 marks)
a) To calculate the current Earnings per Share (EPS) for shareholders, we need to first determine the net income available to common shareholders. We can calculate this by subtracting interest expense and taxes from EBIT.
EBIT (Earnings Before Interest and Taxes) = $3 million
Interest Expense = Debt x Interest Rate = $600,000 x 7% = $42,000
Taxable Income = EBIT - Interest Expense = $3 million - $42,000 = $2,958,000
Taxes = Taxable Income x Tax Rate = $2,958,000 x 20% = $591,600
Net Income Available to Common Shareholders = Taxable Income - Taxes = $2,958,000 - $591,600 = $2,366,400
EPS = Net Income Available to Common Shareholders / Number of Common Shares
Number of Common Shares = Total Shares - Preference Shares = 10,000,000 - 0 = 10,000,000
Current EPS = $2,366,400 / 10,000,000 = $0.237
b) To calculate the EPS after the change in capital structure under option 1 and option 2, we need to consider the impact of the new interest expense and the changes in the number of shares outstanding.
Option 1:
New Interest Expense = New Debt x Interest Rate = $3,500,000 x 8% = $280,000
EBIT = $3 million
Interest Expense = $280,000
Taxable Income = EBIT - Interest Expense = $3 million - $280,000 = $2,720,000
Taxes = Taxable Income x Tax Rate = $2,720,000 x 20% = $544,000
Net Income Available to Common Shareholders = Taxable Income - Taxes = $2,720,000 - $544,000 = $2,176,000
New Number of Common Shares = Current Number of Common Shares - Number of Shares Repurchased = 10,000,000 - 3,500,000 = 6,500,000
EPS under Option 1 = $2,176,000 / 6,500,000 = $0.334
Option 2:
EBIT = $3 million
Interest Expense = Existing Debt x Interest Rate = $600,000 x 7% = $42,000
Taxable Income = EBIT - Interest Expense = $3 million - $42,000 = $2,958,000
Taxes = Taxable Income x Tax Rate = $2,958,000 x 20% = $591,600
Net Income Available to Common Shareholders = Taxable Income - Taxes = $2,958,000 - $591,600 = $2,366,400
New Number of Common Shares = Current Number of Common Shares + Number of New Shares Issued = 10,000,000 + 3,500,000 = 13,500,000
EPS under Option 2 = $2,366,400 / 13,500,000 = $0.175
c) To determine if it makes sense for management to go ahead with either of the capital restructure options, we compare the EPS before and after the change in capital structure. The option that results in an increase in EPS is considered EPS accretive.
Comparing the current EPS ($0.237) with the EPS after the change in capital structure:
- Option 1: EPS increases to $0.334
- Option 2: EPS decreases to $0.175
Based on the comparison, it makes sense for management to go ahead with Option 1 as it is EPS accretive and results in an increase in EPS.
d) The term "capital structure" refers to the composition of a company's long-term funding sources, including debt, equity, and other financial instruments. It represents the way a company finances its operations, investments, and growth.
The optimal capital structure is the one that maximizes the value of the firm and minimizes the weighted average cost of capital (WACC). WACC is the average cost of all sources of financing (debt, equity, etc.) and represents the minimum return required by investors to provide funds to the company.
The optimal capital structure depends on several factors, including the company's industry, risk profile, growth opportunities, and investor preferences. A company's value is maximized when the cost of each source of financing is balanced to create an optimal mix that minimizes the overall cost of capital.
In general, an optimal capital structure is achieved when:
- The company's WACC is minimized, indicating that the cost of capital is optimized.
- The composition of debt and equity balances the benefits of leverage (tax advantages, lower cost of debt) with the costs (increased financial risk, potential bankruptcy).
- The capital structure aligns with the company's long-term financial goals, growth plans, and risk tolerance.