Following the lines of the model by Ross (1977):

I. Explain how firms may use their capital structure to generate a signal that conveys credible information about their future expected returns.

II. In the Ross Model, what is the ‘ingredient' that precludes firms of a lower quality from behaving like firms of higher quality?

Part B:

Evergreen Company Ltd has been promoted by three promoters. They are trying to decide how the company should be financed. There are three choices:

i. Issue Rs 500,000 in Equity shares
ii. Issue Rs 300,000 in equity shares, and Rs 200,000 in 12 % Debentures;
iii. Issue Rs 300,000 in equity shares and Rs 200,000 in 10% Preference shares.

Income before Interest and taxes is expected to be Rs 100,000 per year.

Required:

As a financial controller, suggest which plan you would recommend the Organisation to adopt, when the tax rate is 35 %. Compute the income available for equity shares, return on equity and EPS (assume equity shares are of Rs 100 each).