ABC Limited is a manufacturing company with an all-equity capital structure. The firm is experiencing growth opportunities and needs to make…

CA Intermediate · Financial Management and Strategic Management · MTP · September 2026
ABC Limited is a manufacturing company with an all-equity capital structure. The firm is experiencing growth opportunities and needs to make strategic decisions regarding its capital structure to finance expansion plans. The company currently has 1,00,000 ordinary shares @ ₹ 10 in issue. Its current operational metrics are: Return on Capital Employed (ROCE): 31.25% [Capital Employed = Face Value of Equity Share Capital] Operating Margin (EBIT / Revenue): 31.25% Tax Rate: 50% ABC Limited has identified investment opportunities requiring additional capital equal to 25% of its existing equity base. Management is evaluating three financing alternatives: Option 1 — Equity Financing: Issue ordinary shares at face value Option 2 — Debt Financing: Borrow at 8% per annum Option 3 — Preference Share Financing: Issue preference shares carrying an 8% per annum dividend Preliminary analysis shows that the difference in EPS between the Debt option and the Preference Share option works out to ₹ 0.10 per share. You are required to: 1. Identify which financing alternative, Debt or Preference Shares yields the higher EPS, and explain the reason for the difference. 2. Find the Existing Equity Base, Face Value of Equity Shares, EBIT and Revenue. 3. If the additional finance is raised entirely through equity shares issued at face value, how many new shares should be issued? 4. Assuming the same EBIT, determine the Earnings Per Share (EPS) under each of the three financing alternatives.

Suggested Answer and Working Notes:

1. The Debt option yields the higher EPS. Although the interest rate on debt (8%) equals the dividend rate on preference shares (8%), and both raise the identical amount of additional capital, the two are treated differently for tax purposes: Interest on debt is a charge against profit, it is deducted before computing tax, so it earns a tax shield of (Interest × Tax Rate). Preference dividend is an appropriation of profit, it is paid out of profit after tax, so it earns no tax shield. Because of this tax shield, the after-tax cost of debt is lower than the after-tax cost of preference capital, so more residual earning is left for equity shareholders under the Debt optio, producing a higher EPS. 2. Existing Equity Share Capital (= Capital Employed) is taken as ₹ 10,00,000, with 1,00,000 shares in issue. The EPS gap between Debt and Preference arises purely from the tax shield on interest, and this relationship holds regardless of the size of the existing equity base: Incremental earnings from choosing Debt over Preference = Tax shield on interest = X × 8% × 50% = 0.04X Spread over the unchanged 1,00,000 shares: 0.04X / 1,00,000 = 0.10 ⇒ 0.04X = ₹ 10,000 ⇒ X = 10,000 / 0.04 = 2,50,000 EBIT = ROCE × Capital Employed = 31.25% × ₹ 10,00,000 = ₹ 3,12,500 Revenue = EBIT ÷ Operating Margin = ₹ 3,12,500 ÷ 31.25% = ₹ 10,00,000 3. New shares = Additional Funds ÷ Face Value = ₹ 2,50,000 ÷ ₹ 10 = 25,000 shares Total shares after issue = 1,00,000 (existing) + 25,000 (new) = 1,25,000 shares 4. Evaluation of alternative options Particulars Option 1 (Equity) Option 2 (Debt) Option 3 (Pref. Shares) Revenue (₹) 10,00,000 10,00,000 10,00,000 EBIT (31.25% of Capital Employed) (₹) 3,12,500 3,12,500 3,12,500 Less: Interest (8% of ₹ 2,50,000) (₹) Nil 20,000 Nil Earnings Before Tax (₹) 3,12,500 2,92,500 3,12,500 Less: Tax @ 50% (₹) 1,56,250 1,46,250 1,56,250 Earnings After Tax (₹) 1,56,250 1,46,250 1,56,250 Less: Preference Dividend (8% of ₹ 2,50,000) (₹) 20,000 Earnings available to equity shareholders (₹) 1,56,250 1,46,250 1,36,250 Number of Equity Shares 1,25,000 1,00,000 1,00,000 Earnings Per Share (EPS) 1.25 1.46 1.36

Topics: Part-A: Financial Management

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