Newcap Ltd has an ordinary share capital of 400,000 shares fully paid to $1 and a 10% preference share capital of 100,000 shares fully paid to $1. Additional funds of $600,000 are required for expansion. The company is considering introducing some debt funds to its capital structure and wants you to evaluate the effects on earning per share of the following alternatives:
a) Issue 600,000 fully paid ordinary shares for $1 each.
b) Issue 300,000 fully paid ordinary shares for $1 each and $300,000 15% debentures.
c) Issue $600,000 15% debentures.
I. The degree of financial leverage for the alternatives (a), (b) and (c).
II. At what levels of earnings before interest and tax would Newcap Ltd be indifferent as to the choice between alternative (a) and (c)? Show calculation in order to prove it.
Earnings before interest and taxes (EBIT) are expected to be $400,000 with a company tax rate of 27.5%