Reference no: EM132725461

Question - ABC Ltd plans to raise an additional $500,000 for long term investment. It can raise these funds in one of three possible ways:

(i) An issue of 500,000 ordinary shares at $1.00

(ii) An issue of $500,000 10% debentures

(iii) An issue of 250,000 ordinary shares at $1.00 and $250,000 10% debentures

The capital structure of the company presently consists of:

(i) 1,000,000 ordinary shares of $1 each fully paid

(ii) 100,000 7% preference shares of $1 each fully paid

(iii) $400,000 12% debentures

It is expected that the earnings before interest and tax of ABC Ltd will be $500,000. The company pays an income tax at the rate of 30%.

Required -

(a) Calculate the earnings per share for each proposal.

(b) Calculate the degree of financial leverage resulting from each proposal.

(c) Calculate the indifference point using EBIT between alternative (i) and (ii). Explain the meaning of your answer.

(d) Calculate the earnings per share for both options based on your indifference point calculations.

(e) Decide which of the three proposals should be implemented using earnings per share as the basis of your decision.

(f) Should the company make its choice solely on earnings per share or should other factors be considered?