11 February 2023
Q.5 The following figures of Ram Ltd are presented as under: EBIT Rs. 23,00,000 Less: Debenture Interest @ 8% Rs. 80,000 Long Term Loan Interest @ 11% Rs. 2,20,000 PBT Rs. 20,00,000 Less: Income Tax Rs. 10,00,000 PAT Rs. 10,00,000 EPS Rs. 2 MPS Rs. 20 PE 10 The Company has undistributed reserves and surplus of Rs. 20 Lakhs. It is in need of Rs. 30 Lakhs to payoff debentures and modernize its plants. It seeks your advice on the following alternative modes of raising finance. Alternative 1: Raising entire amount as term loan from banks at 12 percent Alternative 2: Raising part funds by issue of 1,00,000 shares of Rs. 20 each and the rest by term loan at 12% The company expects to improve its Rate of Return by 2% as a result of modernization, but PE is likely to go down to 8, if entire amount is raised as Term Loan. Advise the company on the Financial Plan to be selected.
07 July 2024
To advise Ram Ltd on the best financial plan considering the alternatives provided, let's analyze each option based on the given information.
### Alternative 1: Raising entire amount as term loan from banks at 12%
**Details:** - Amount needed: Rs. 30 Lakhs - Rate of interest: 12% - Expected improvement in Rate of Return (RoR): +2% - Impact on Price-Earnings (PE) ratio: PE expected to decrease to 8
**Financial Impact Analysis:** 1. **Interest Expense:** - Interest on Rs. 30 Lakhs at 12%: Rs. 3,60,000 per annum
2. **Impact on Earnings:** - Earnings Before Interest and Taxes (EBIT): Rs. 23,00,000 - Less: Interest Expense: Rs. 3,60,000 - Profit Before Tax (PBT): Rs. 19,40,000 - Less: Income Tax (assuming similar rate): Rs. 9,70,000 - Profit After Tax (PAT): Rs. 9,70,000
3. **Earnings per Share (EPS):** - Current EPS: Rs. 2 - Expected new EPS after financing: To be calculated after issuance of new shares, if any.
4. **Return on Equity (RoE):** - Assuming equity remains the same, RoE will be impacted by the increase in interest expense and potential decrease in profitability.
5. **Impact on Price-Earnings (PE) Ratio:** - PE ratio expected to decrease to 8 due to higher interest expenses impacting profitability.
### Alternative 2: Raising part funds by issue of 1,00,000 shares of Rs. 20 each and the rest by term loan at 12%
**Details:** - Issue of 1,00,000 shares at Rs. 20 each: Rs. 20,00,000 - Remaining amount to be financed: Rs. 10,00,000 (term loan at 12%)
**Financial Impact Analysis:** 1. **Interest Expense:** - Interest on Rs. 10,00,000 at 12%: Rs. 1,20,000 per annum
2. **Impact on Earnings:** - Earnings Before Interest and Taxes (EBIT): Rs. 23,00,000 - Less: Interest Expense: Rs. 1,20,000 - Profit Before Tax (PBT): Rs. 21,80,000 - Less: Income Tax (assuming similar rate): Rs. 10,90,000 - Profit After Tax (PAT): Rs. 10,90,000
3. **Earnings per Share (EPS):** - Calculation required after considering new shares issued.
4. **Return on Equity (RoE):** - Impact on RoE needs to be calculated considering the new equity infusion.
5. **Impact on Price-Earnings (PE) Ratio:** - PE ratio needs recalculation after determining the new EPS and considering the issuance of new shares.
### Advice to Ram Ltd:
1. **Evaluation Criteria:** - **Financial Risk:** Consider the impact of higher debt burden on profitability and liquidity. - **Return Enhancement:** Evaluate if the expected increase in RoR justifies the higher interest costs. - **Market Reaction:** Assess investor sentiment regarding the potential decrease in PE ratio.
2. **Recommendation:** - **Alternative 2 (Mix of Equity and Debt):** This option spreads the financing between equity and debt, reducing the immediate debt burden and potential impact on PE ratio compared to Alternative 1. - **Benefits:** By issuing shares, Ram Ltd can avoid the full impact of increased debt servicing costs and maintain a more favorable PE ratio, although dilution effects on EPS and RoE need careful consideration.
3. **Implementation Strategy:** - Proceed with issuing 1,00,000 shares to raise Rs. 20 Lakhs. - Secure the remaining Rs. 10 Lakhs through a term loan at 12%, keeping the overall interest burden manageable while achieving the necessary funds for modernization.
4. **Monitoring and Adjustment:** - Monitor financial performance closely post-financing to ensure expected improvements in RoR materialize. - Consider adjustments to capital structure in the future based on market conditions and financial performance.
By adopting Alternative 2, Ram Ltd can balance its financing needs effectively while mitigating potential risks associated with high debt levels and adverse market reactions related to the PE ratio.
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