ABC Ltd. is planning to raise - 50,00,000 for a major expansion project. The firm is evaluating three financing options: (i) Equity Financing Only…

CA Intermediate · Financial Management and Strategic Management · RTP · September 2025
ABC Ltd. is planning to raise - 50,00,000 for a major expansion project. The firm is evaluating three financing options: (i) Equity Financing Only Issuing new shares at 10 each (Issue price:10, but flotation cost per share:0.50).Existing equity shares: 10,00,000.Market price per share:20. (ii) Debt Financing Only Borrow - 50,00,000 at 12% interest.Flotation cost on debt: 2% of the face value.The lender imposes a debt covenant limiting the interest coverage ratio (EBIT/Interest) to a minimum of 2.5. (iii) Mix of Equity and Debt Financing Raise - 25,00,000 through equity (floatation cost:0.50/share at 10 issue price).Raise - 25,00,000 through debt at 12% interest (floatation cost: 2%). Additional Information (i) Project EBIT:15,00,000 annually. (ii) Corporate tax rate: 30%. (iii) Existing shares: 10,00,000. (iv) Risk-free rate: 6%, Market return: 14%, Equity beta: 1.2. From the above information: CALCULATE the net proceeds from each financing method (after floatation costs) and determine the number of new shares issued in Option (i) and Option (iii).For debt options, CHECK if the interest coverage ratio complies with the covenant (minimum 2.5).COMPUTE EPS under each option.COMPUTE the WACC under each option, considering the impact of floatation costs on capital raised. ADVISE which financing option is best from both an EPS and WACC perspective.

Suggested Answer and Working Notes:

(i) Calculation of Net Proceeds after Floatation Cost and Number of New Shares in Option (i) and (iii) Equity Option Net proceeds per share = 10 -0.50 = 9.50 Number of shares issued = 50,00,000 /9.50 = 5,26,316 shares Debt Option Flotation cost = 2% of 50,00,000 = 1,00,000 Net proceeds = 50,00,000 - 1,00,000 = 49,00,000 But project requires - 50,00,000. So gross borrowing = 50,00,000 / (1 – 0.02) = 51,02,041 Interest = 12% × ₹ 51,02,041 = 6,12,245 Mix Option (25 lakh Equity,25 lakh Debt) Equity Net proceeds/share = 9.50 Shares issued = 25,00,000 /9.50 = 2,63,158 shares Debt Net debt proceeds = 25,00,000. Gross borrowing = 25,00,000 / (1 – 0.02) = 25,51,020 Interest = 12% × ₹ 25,51,020 = 3,06,122 (ii) Calculation of Interest Coverage Ratio (ICR) ICR = EBIT / Interest Debt Option: EBIT = 15,00,000 Interest = 6,12,245 ICR = 15,00,000 /6,12,245 ≈ 2.45 (Fails covenant) Mix of Equity and Debt Option Interest = 3,06,122 ICR = 15,00,000 /3,06,122 ≈ 4.90 (Passes covenant) (iii) Calculation of Earnings Per Share (EPS) EPS = (EBIT-Interest) (1-Tax) / Total Shares Equity Option Interest = 0 Net Income = 15,00,000 × (1 – 0.30) = 10,50,000 Total Shares = 10,00,000 + 5,26,316 = 15,26,316 EPS = 10,50,000 / 15,26,316 = 0.688 Debt Option (Fails covenant) Interest = 6,12,245 Net Income = (₹ 15,00,000 - 6,12,245) × (1 – 0.30) = 6,21,428.5 Total Shares = 10,00,000 EPS = 6,21,428.5 / 10,00,000 = 0.621 (But violates ICR) Mix Option Interest = 3,06,122 Net Income = (₹ 15,00,000 - 3,06,122) × 0.70 = 8,35,714.6 Total Shares = 10,00,000 + 2,63,158 = 12,63,158 EPS = 8,35,714.6 / 12,63,158 ≈ ₹ 0.662 (iv) Calculation of WACC Cost of Equity (Using CAPM) Cost of Equity = R f +β(R m -R f ) = 6%+1.2 × (14%-6%) = 6%+9.6%=15.6% Now, WACC = (E/V×K e ) + (D/V×K d ×(1-t)) Equity Option E = 50,00,000 D = 0 WACC = 15.6% Debt Option E = 0 D = 51,02,041 K d = 12% After-tax cost of debt = 12% × (1 – 0.30) = 8.4% WACC = 8.4% (Lowest WACC but fails covenant) Mix Option E = 25,00,000, D = 25,51,020 Total Value = 50,51,020 K e = 15.6%, K d (after tax) = 8.4% WACC = (Weight of K e x Cost of Equity) + (Weight of K d x Cost of Debt) = (0.495 x 0.156) + (0.505 x 0.084) = 0.0772 + 0.0424 = 0.1196 or 11.96% Conclusion & Recommendation Option EPS WACC Covenant Compliant Equity 0.688 15.6% Not Applicable Debt 0.621 8.4% No (ICR < 2.5) Mix 0.662 11.96% Yes Hence, the recommended option is Mixed Financing as it complies with the debt covenant, has higher EPS than Debt Option, and lower WACC than Equity Option.

Topics: Part-A: Financial Management

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