(a) Earning per share before diversification = Rs.0.50
Calculation of Earning per share after issue of Debentures: (assuming face value of Rs.100 per share)
This clearly shows that the shareholders have gained after the issue of debentures since tire Earning per share has increased from Rs.0.50 to Rs.4.
or
Calculation of Earning per share after issue of Debentures: (assuming face value of Rs.10 per share)
This clearly shows that the shareholders have lost after the issue of debentures since the Earning per share has decreased from Rs.0.50 to Rs.0.40.
[Note: In case, a student has calculated Return on Investment as 8% (8,00,000/Rs.1,00,00,000) and compared it with the rate of interest which is 10% and concluded that the shareholders have lost after the issue of Debentures since the interest rate is greater than the Return of Investment]
[In case the examinee has assumed any other face value and has shown correct calculation and given the correct conclusion, full credit by given.]
(b) Factors that favour issue of debentures by the company:
(i) A good cash flow position makes debt funding more viable.
(ii) High Interest Coverage ratio lowers the risk of company failing to meet its interest payment obligations
(iii) High debt service coverage ratio indicates better ability to meet the debt service obligations.
(iv) If Return on Investment of the company is higher than the interest rate on debt, its ability to use debt is greater.
(v) Lower the cost of debt higher is the ability to employ debt.
(vi) High tax rate makes debt relatively cheaper.
(vii) If the stock market conditions are bearish, a company may be able to easily raise funds through debt.
(viii)If the company does not want dilution of control, it will favour debt as a source of finance.
(ix) Inclusion of debt in the capital structure makes the capital structure flexible.
(x) If the business risk is lower its capacity to use debt is higher.
(xi) Raising funds through debt involves low floatation costs.
