The management of One-M Berhad is considering an expansion project for their current business. RM125,000 is needed for the expansion and two options has been proposed. Under Option I, the project will be financed by issuing new common stocks that can be sold for RM5 per share. Option II involves the use of financial leverage. A 10-year bond can be issued with 8% coupon rates. The company corporate income tax is 30% and the existing preferred stock pay dividends of RM4 per share. The existing capital structures for One-M Berhad are as follows:
Bonds: RM
(9% RM1,000 par value) 20,000
Preferred Stock:
(RM25 par value) 15,000
Common Stock:
(RM2 par value) 25,000
Questions:
a) Calculate the indifference point of EBIT-EPS for the two financial proposals.
b) If EBIT is expected to be RM 20,000, which financial proposal should you select? Why? (show your calculation)
a) To calculate the indifference point of EBIT-EPS for the two financial proposals, we need to find the level of EBIT (Earnings Before Interest and Taxes) at which the earnings per share (EPS) would be the same for both options.
Let's start with Option I, which involves issuing new common stocks:
1. Calculate the number of shares that need to be issued:
Amount needed for expansion / Issue price per share
= RM125,000 / RM5
= 25,000 shares
2. Calculate the EPS for Option I:
EPS = (EBIT - Interest) * (1 - Tax rate) / Number of shares
Since there is no interest expense for Option I, the equation simplifies to:
EPS = (EBIT * (1 - Tax rate)) / Number of shares
Now let's move on to Option II, which involves issuing a bond with a coupon rate of 8%:
1. Calculate the annual interest expense for the bond:
Bond value * Coupon rate
= RM20,000 * 8% = RM1,600
2. Calculate the EPS for Option II:
EPS = (EBIT - Interest - Preferred stock dividends) * (1 - Tax rate) / Number of shares
Now, we need to find the EBIT at which the EPS for both options is the same. Set the EPS for Option I equal to the EPS for Option II and solve for EBIT.
(EBIT * (1 - Tax rate)) / Number of shares = (EBIT - Interest - Preferred stock dividends) * (1 - Tax rate) / Number of shares
Simplifying the equation,
EBIT * (1 - Tax rate) = EBIT - Interest - Preferred stock dividends
EBIT - EBIT * (1 - Tax rate) = Interest + Preferred stock dividends
EBIT - EBIT + (EBIT * Tax rate) = Interest + Preferred stock dividends
EBIT * Tax rate = Interest + Preferred stock dividends
EBIT = (Interest + Preferred stock dividends) / Tax rate
Now we can substitute the values provided to find the indifference point of EBIT-EPS.
b) If EBIT is expected to be RM20,000, we can calculate the EPS for both options and compare them.
For Option I:
EPS = (EBIT * (1 - Tax rate)) / Number of shares
= (RM20,000 * (1 - 0.3)) / 25,000 shares
= RM14,000 / 25,000 shares
= RM0.56 per share
For Option II:
EPS = (EBIT - Interest - Preferred stock dividends) * (1 - Tax rate) / Number of shares
= (RM20,000 - RM1,600 - RM4,000) * (1 - 0.3) / 25,000 shares
= (RM14,400) * (0.7) / 25,000 shares
= RM10,080 / 25,000 shares
= RM0.40 per share
Comparing the EPS values, Option I has a higher EPS of RM0.56 per share, while Option II has a lower EPS of RM0.40 per share.
Therefore, if EBIT is expected to be RM20,000, Option I should be selected because it offers a higher EPS, which means better earnings per share for the shareholders.