Krish limited is in the business of manufacturing and exporting carpets and other home décor products……………….

Question 12:Krish limited is in the business of manufacturing and exporting carpets and other home décor products. It has a share capital of ₹ 70 lacs at the face value of ₹ 100 each. Company is considering a major expansion of its production facilities and wants to raise ₹ 50 lacs. The finance manager of the company Mr. Prabhakar has recommended that the company can raise funds of the same amount by issuing 7% debentures. Given that earning per share of the company after expansion is ₹ 35 and tax rate is 30%, did Mr. Prabhakar give a justified recommendation? Show the working.

The correct answer is – To determine if Mr. Prabhakar’s recommendation to issue 7% debentures is justified, we need to calculate the cost of equity and the cost of debt, and compare them to the cost of capital.

Given information:

• Share capital = ₹70 lacs at the face value of ₹100 each

• Company wants to raise ₹50 lacs

• Earning per share after expansion = ₹35

• Tax rate = 30%

Step 1: Calculate the cost of equity The cost of equity can be calculated using the Capital Asset Pricing Model (CAPM). CAPM = Risk-free rate + Beta x (Market rate of return – Risk-free rate)

Assuming a risk-free rate of 6%, a market rate of return of 12%, and a beta of 1.2, we get: Cost of equity = 6% + 1.2 x (12% – 6%) = 13.2%

Step 2: Calculate the cost of debt The cost of debt is given as 7%.

Step 3: Calculate the cost of capital The cost of capital is the weighted average of the cost of equity and the cost of debt, based on the proportion of equity and debt in the company’s capital structure.

Assuming the company has a debt-to-equity ratio of 1:2, we get: Weighted average cost of capital = (2/3 x 13.2%) + (1/3 x 7%) = 11.2%

Step 4: Determine if Mr. Prabhakar’s recommendation is justified The company can raise ₹50 lacs by issuing 7% debentures. The interest expense on these debentures will be 7% x ₹50 lacs = ₹3.5 lacs.

The earnings before interest and taxes (EBIT) of the company after expansion will be: EBIT = Earning per share x Number of shares EBIT = ₹35 x (₹70 lacs / ₹100) = ₹24.5 lacs

The interest expense on the debentures is tax-deductible, so the company’s taxable income will be: Taxable income = EBIT – Interest expense Taxable income = ₹24.5 lacs – ₹3.5 lacs = ₹21 lacs

The tax payable by the company will be: Tax payable = Tax rate x Taxable income Tax payable = 30% x ₹21 lacs = ₹6.3 lacs

The net income of the company after paying interest and taxes will be: Net income = EBIT – Interest expense – Tax expense Net income = ₹24.5 lacs – ₹3.5 lacs – ₹6.3 lacs = ₹14.7 lacs

The return on equity (ROE) of the company can be calculated as: ROE = Net income / Shareholders’ equity ROE = ₹14.7 lacs / ₹70 lacs = 21%

Since the cost of equity is 13.2% and the ROE is 21%, it appears that Mr. Prabhakar’s recommendation to issue 7% debentures is justified, as the cost of debt is lower than the cost of equity and the cost of capital.