question_answer

KAY Ltd is a company manufacturing textiles. It has a share capital of Rs. 60 lakh. In the previous year its earning per share was Rs. 0.50. For diversification, the company requires additional capital of Rs. 40 lakh. The company raised funds by issuing 10% debentures for the same. During the year, the company earned profit of Rs. 8 lakh on capital employed. It paid tax @ 40%.

(i) State whether the shareholders gained or lost, in respect of earning per share on diversification. Show your calculations clearly.

(ii) Also, state any three factors that favour the issue of debentures by the company as part of its capital structure.

Answer:

Particulars	Amt (Rs.)
Profit before Interest and Tax (-) Debentures Interest \[\left( 40,00,000\times \frac{10}{100} \right)\]	8,00,000 (4,00,000)
Profit after Interest (-) Tax \[\left( 4,00,000\times \frac{40}{100} \right)\]	4,00,000 (1,60,000)
Profit after Tax Earning per Share	2,40,000
	\[\frac{\Pr ofit\,after\,Tax}{Number\,of\,Shares}=\frac{2,40,000}{6,40,000}=0.40\]

Since, earning per share has fallen from 0.50 to 0.40, therefore the shareholders stand to lose on diversification. Note In the absence of any information, shares are assumed to be of Rs. 10 each. So, Number of Shares \[=\frac{Share\,Capital}{Face\,Value\,Share}=\frac{60,00,000}{10}=6,00,000\,Shares\] (ii) Three factors that favour issue of debentures by the company as part of its capital structure are: [a] Debenture interest payable is a charge to the profits. Hence, a company stands to gain in terms of tax benefits. [b] Issue of debentures help the shareholders of the company to gain through Trading on Equity'. [c] Debenture is a cheaper source of finance as compared to equity.