Capital Structure - castudyweb.com...a) Capital Structure: 㾎The firm should strive to reach the optimal capital structure and its total valuation through a judicious use of the both

CA INTER FM ECO

CHAPTER 5

Capital Structure- CA Mayank Kothari

Theory Questions Numericals

40 44

CA Inter FM-ECO CA Mayank Kothari

Chapter 5 Financing Decisions-Capital Structure 1. Explain the meaning of the term “Capital Structure”. Answer:

✓ Capital structure is the combination of capitals from different sources of finance, primarily consisting of equity share holders’ fund, preference share capital and long term external debts.

✓ The source and quantum of capital is decided on the basis of need of the company and the cost of the capital.

✓ However, the prime objective of a company is to maximize the value of the company while deciding the optimal capital structure.

2. How do we calculate value of a firm? Answer:

✓ The value of firm is calculated as below:

!

!

!

Where, ! = Weighted average cost of capital ! = Cost of Debt D = Market value of debt S = Market value of equity ! = Cost of equity

Value of the firm =EBIT

Overall cost of capital or Weighted average cost of capital

K0 = (Cost of debt × weight of debt) + (Cost of equity × weight of equity)

K0 = [{Kd × D/(D + S)} + {Ke × S/(D + S)}]

K0

Kd

Ke

Page � of �1 55


3. What do you mean by capital structure decision? How is it relevant in maximizing the value of the firm and minimizing overall cost of capital?

Answer: ✓ Capital Structure decision refers to deciding the sources of financing, the

amount to be funded and their relative proportions (mix) in total capitalization.

✓ Whenever funds are to be raised to finance investments, capital structure decision is involved.

✓ It helps in deciding weight of debt and equity and ultimately overall cost of capital as well as Value of the firm.

✓ So ultimately, capital structure is relevant in maximizing value of the firm and minimizing overall cost of capital.

4. There are different approaches taken to explain the relationship between cost of capital, capital structure and value of the firm. Depict those approaches.

Answer: The following are the different approaches:

Page � of �2 55

Capital Structure Theories

CS Relevance Theories

CS Irrelevance Theory

Net Income Approach

Net Operating Income Approach

Traditional Approach

Modigliani Miller Approach


1. Net Income (NI) Approach 2. Traditional Approach 3. Net Operating Income (NOI) Approach 4. Modigilani-Miller (MM) Approach

5. To understand the relationship between cost of capital, capital structure and value of the firm, a number of assumptions are taken. Mention those assumptions.

Answer: The assumptions taken while understanding the relationship are mentioned as below:

✓ There are only two kinds of funds used by a firm i.e. debt and equity. ✓ The total assets of the firm are given. The degree of average can be

changed by selling debt to purchase shares or selling shares to retire debt.

✓ Taxes are not considered. ✓ The payout ratio is 100%. ✓ The firm’s total financing remains constant. ✓ Business risk is constant over time. ✓ The firm has perpetual life.

6. As per the Net Income (NI) Approach, explain how the capital structure decision affects weighted average cost of capital (WACC) thereby affecting the value of the firm as well as market price of shares.

Answer: ✓ Capital structure decision primarily helps in deciding weight of debt and

equity and ultimately overall cost of capital as well as Value of the firm & the market price of shares.

✓ An increase in financial leverage will lead to decline in the weighted average cost of capital (WACC), while the value of the firm as well as market price of ordinary share will increase.

✓ Conversely, a decrease in the leverage will cause an increase in the overall cost of capital and a consequent decline in the value as well as market price of equity shares. Thus as debt increases, WACC decreases.

✓ Thus, under the NI approach, the value of the firm & market price of shares will be maximum when WACC is minimum.

Page � of �3 55


✓ On point to remember is that in both the above situation, it is assumed that ! and ! do not change with leverage.

7. How under the Net Income approach (NI), the firm can increase its total value?

Answer: ✓ Under the NI approach, the value of the firm & market price of shares

will be maximum when WACC is minimum. ✓ Thus according to this approach, the firm can increase its total value by

decreasing its overall cost of capital through increasing the degree of leverage.

✓ Thus, to achieve highest market price of shares and highest value of the firm, total or maximum possible debt financing should be done to minimize the cost of capital.

✓ The significant conclusion of this approach is that it pleads for the firm to employ as much debt as possible to maximize its value.

8. How do we calculate the value of the firm on the basis of Net Income (NI) Approach?

Answer: The value of the firm on the basis of Net Income (NI) Approach is given by,

! Where, V = Value of the firm S = Market value of equity D = Market value of debt

9. Provide how market value of equity is calculated. Answer: The market value of equity is calculated as below:

!

Where, NI = Earnings available for equity shareholders ! = Equity Capitalization rate

Ke Kd

Value of the firm(V) = S + D

Market value of equity (S) =NIKe

Ke

Page � of �4 55


10.How will you calculate overall cost of capital under Net Income (NI) Approach?

Answer: ✓ The overall cost of capital under this approach is :

!

✓ Thus according to this approach, the firm can increase its total value by decreasing its overall cost of capital through increasing the degree of leverage.

✓ The significant conclusion of this approach is that it pleads for the firm to employ as much debt as possible to maximize its value.

11.Explain traditional approach used to explain the capital structure theory (that is, the relationship between cost of capital, capital structure and value of the firm). Also explain with reference to the traditional approach where optimal capital structure is obtained?

Answer: ✓ Traditional approach favors that as a result of financial leverage up to

some point, cost of capital comes down and value of firm increases. However, beyond that point, reverse trends emerge.

✓Under this approach it is believed that there is an optimal capital structure which minimizes the cost of capital.

✓At the optimal capital structure, the real marginal cost of debt and equity is the same.

✓ Before the optimal point, the real marginal cost of debt is less than real marginal cost of equity and beyond this optimal point the real marginal cost of debt is more than real marginal cost of equity.

✓Optimum capital structure occurs at the point where value of the firm is highest and the cost of capital is the lowest.

Overall cost of capital =EBIT

Value of the firm

Page � of �5 55


12.Explain treatment of capital structure decisions under different approaches used to explain capital structure theory.

Answer: ✓As per the Net Income approach capital structure decision primarily

helps in deciding weight of debt and equity and ultimately decides overall cost of capital as well as Value of the firm & the market price of shares.

✓However, according to net operating income approach, capital structure decisions are totally irrelevant.

✓Modigliani-Miller supports the net operating income approach but provides behavioral justification.

✓ The traditional approach, on the other hand strikes a balance between Net operating income approach and Modigliani-Miller approach (that is, between extremes).

13.What according to you are the main highlights of traditional approach? Answer: The main highlights of traditional approach are mentioned as below:

a) Capital Structure: ✓ The firm should strive to reach the optimal capital structure and its

total valuation through a judicious use of the both debt and equity in capital structure.

✓At the optimal capital structure, the overall cost of capital will be minimum and the value of the firm will be maximum.

b) Financial Leverage: ✓Value of the firm increases with financial leverage up to a certain

point. ✓ Beyond this point the increase in financial leverage will increase its

overall cost of capital and hence the value of firm will decline. ✓ This is because the benefits of use of debt may be so large that even

after offsetting the effect of increase in cost of equity, the overall cost of capital may still go down.

✓However, if financial leverage increases beyond an acceptable limit, the risk of debt investor may also increase, consequently cost of debt also starts increasing.

Page � of �6 55


✓ The increasing cost of equity owing to increased financial risk and increasing cost of debt makes the overall cost of capital to increase.

14.Explain Net operating Income approach (NOI)? Answer:

✓Net operating Income means earnings before interest and tax (EBIT). According to this approach, capital structure decisions of the firm are irrelevant.

✓Any change in the leverage will not lead to any change in the total value of the firm and the market price of shares, as the overall cost of capital is independent of the degree of leverage.

✓As a result, the division between debt and equity is irrelevant. ✓As per this approach, an increase in the use of debt which is apparently

cheaper is offset by an increase in the equity capitalization rate. ✓ This happens because equity investors seek higher compensation as

they are opposed to greater risk due to the existence of fixed return securities in the capital structure.

15.Explain how Modigliani-Miller approach (MM) is different from Net operating Income approach (NOI)? Also mention how Modigliani-Miller approach is classified.

Answer: ✓ The NOI approach is conceptual and lacks behavioral significance. It

does not provide operational justification for irrelevance of capital structure.

✓However, Modigliani-Miller’s approach provides behavioral justification for constant overall cost of capital and therefore, totals value of the firm.

✓Modigliani-Miller approach can be classified as below: A. MM approach-1958 : without tax B. MM approach-1963 : with tax

Page � of �7 55


16.Briefly explain “MM approach-1958: without tax”. Also mention assumptions considered under this approach.

Answer: ✓ This approach describes that in a perfect capital market where there is

no transaction cost and no taxes, the value and cost of capital of a company remain unchanged irrespective of change in the capital structure.

✓ The approach is based on further additional assumptions like: 1. Capital markets are perfect. All information is freely available and

there are no transaction costs. 2. All investors are rational. 3. Firms can be grouped into ‘Equivalent risk classes’ on the basis of

their business risk. 4. Non-existence of corporate taxes.

17.Briefly mention the propositions derived based on the assumptions under Modigliani-Miller approach.

Answer: The following propositions have been derived based on the assumptions under Modigliani-Miller approach:

i. Total market value of a firm is equal to its expected net operating income divided by the discount rate appropriate to its risk class decided by the market.

!

!

ii. A firm having debt in capital structure has higher cost of equity than an unlevered firm. The cost of equity will include risk premium for the financial risk. The cost of equity in a levered firm is determined as under:

!

Value of levered firm(Vg) = Value of unlevered firm(Vu)

Value ofa firm =Net Operating Income (NOI)

K0

Ke = K0 + (K0 − Kd)Debt

Equity

Page � of �8 55


iii.The structure of the capital (financial leverage) does not affect the overall cost of capital. The cost of capital is only affected by the business risk.

18.Explain the operational justification of Modigliani-Miller approach. Answer:

✓ The operational justification of Modigliani-Miller hypothesis is explained through the functioning of the arbitrage process and substitution of corporate leverage by personal leverage.

✓Arbitrage refers to buying asset or security at lower price in one market and selling it at a higher price in another market. As a result, equilibrium is attained in different markets.

✓ This is illustrated by taking two identical firms of which one has debt in the capital structure while the other does not.

✓ Investors of the firm whose value is higher will sell their shares and instead buy the shares of the firm whose value is lower.

✓ They will be able to earn the same return at lower outlay with the same perceived risk or lower risk. They would, therefore, be better off.

✓ The value of the levered firm can neither be greater nor lower than that of an unlevered firm according this approach.

✓ The two must be equal. There is neither advantage nor disadvantage in using debt in the firm’s capital structure.

✓No matter how the capital structure of a firm is divided (among debt, equity etc.), there is a conservation of investment value.

✓ Since the total investment value of a corporation depends upon its underlying profitability and risk, it is invariant with respect to relative changes in the firm’s financial capitalization.

✓According to MM, since the sum of the parts must equal the whole, therefore, regardless of the financing mix, the total value of the firm stays the same.

Page � of �9 55


19.Explain the shortcomings of Modigliani-Miller approach. Answer: The main shortcoming of this approach is that the arbitrage process as suggested by Modigliani-Miller will fail to work because of:

a) Imperfections in capital market, b) Existence of transaction cost and c) Presence of corporate income taxes.

20.Briefly explain the MM approach-1963: with tax. Answer:

✓ In 1963, MM model was amended by incorporating tax. ✓ They recognized that the value of the firm will increase or cost of

capital will decrease where corporate taxes exist. ✓As a result, there will be some difference in the earnings of equity and

debt-holders in levered and unlevered firm and value of levered firm will be greater than the value of unlevered firm by an amount equal to amount of debt multiplied by corporate tax rate.

✓MM has developed the following formulae for computation of cost of capital ( ! ), cost of equity ( ! ) for the levered firm.

1. ! Or, !

2. !

Where, ! = Cost of equity in a levered company

! = Cost of equity in an unlevered company ! = Cost of debt t = Tax rate

3.!

Where, ! = WACC of levered company

KO Ke

Value of levered company = Value of unlevered company + Tax benefit

Vg = Vu + TB

Cost of equity in a levered firm(Keg) = Keu + (Keu − Kd)Debt

Debt + Equity

Keg

KeuKd

WACC in a levered company(Kog) = Keu(1 − tL)

Kog

Page � of �10 55


! = Cost of equity in an unlevered company ! = Tax Rate

!

21.Briefly explain the trade-off theory of capital structure as per Modigliani-Miller approach?

Answer: ✓ The trade-off theory of capital structure refers to the idea that a

company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits.

✓An important purpose of the trade-off theory of capital structure is to explain the fact that corporations usually are financed partly with debt and partly with equity.

✓ It states that there is an advantage to financing with debt, the tax benefits of debt and there is a cost of financing with debt, the costs of financial distress including bankruptcy costs of debt and non-bankruptcy costs (e.g. staff leaving, suppliers demanding disadvantageous payment terms, bondholder/stockholder infighting, etc.).

✓ The marginal benefit of further increases in debt declines as debt increases, while the marginal cost increases, so that a firm that is optimizing its overall value will focus on this trade-off when choosing how much debt and equity to use for financing.

✓According to Modigliani and Miller, the attractiveness of debt decreases with the personal tax on the interest income.

KeuT

L =Debt

Debt + Equity

Page � of �11 55


22.Briefly explain the different concepts that the trade-off theory of capital structure primarily deals with.

Answer: Trade-off theory of capital structure primarily deals with the two concepts - cost of financial distress and agency costs.

A. Financial Distress cost or Bankruptcy cost of debt: ✓ A firm experiences financial distress when the firm is unable to

cope with the debt holders’ obligations. ✓ If the firm continues to fail in making payments to the debt

holders, the firm can even be insolvent. ✓ The direct cost of financial distress refers to the cost of insolvency

of a company. ✓ Once the proceedings of insolvency start, the assets of the firm

may have to be sold at distress price, which is generally much lower than the current values of the assets.

✓ Also a huge amount of administrative and legal costs is also associated with the insolvency.

✓ Even if the company is not insolvent, the financial distress of the company may include a number of indirect costs like – cost of employees, cost of customers, cost of suppliers, cost of investors, cost of managers and cost of shareholders.

B. Agency Cost: ✓ The firms may often experience a dispute of interests among the

management of the firm, debt holders and shareholders. ✓ These disputes generally give birth to agency problems that in

turn give rise to the agency costs. ✓ The agency costs may affect the capital structure of a firm. ✓ There may be two types of conflicts - shareholders-managers

conflict and shareholders- debt-holders conflict.

Page � of �12 55


23.Briefly explain the concept of Pecking Order theory. Answer:

✓ This theory is based on Asymmetric information, which refers to a situation in which different parties have different information.

✓ In a firm, managers will have better information than investors. ✓ This theory states that firms prefer to issue debt when they are positive

about future earnings. Equity is issued when they are doubtful and internal finance is insufficient.

✓ The pecking order theory argues that the capital structure decision is affected by manager’s choice of a source of capital that gives higher priority to sources that reveal the least amount of information.

✓ The name ‘PECKING ORDER’ theory is given as there is no well-defined debt equity target and there are two kind of equity internal and external.

✓ Pecking order theory suggests that managers may use various sources for raising fund in the following order.

1. Managers first choice is to use internal finance 2. In absence of internal finance they can use secured debt,

unsecured debt, hybrid debt etc. 3. Managers may issue new equity shares as a last option.

✓ So briefly under this theory rules are Rule 1: Use internal financing first. Rule 2: Issue debt next Rule 3: Issue of new equity shares at last

24.Mention the different sources from which a firm can choose to raise funds. Answer: A firm has the choice to raise funds for financing its investment proposals from different sources in different proportions. They are mentioned as below:

a) Exclusively use debt (in case of existing company), or b) Exclusively use equity capital, or c) Exclusively use preference share capital (in case of existing company),

or d) Use a combination of debt and equity in different proportions, or e) Use a combination of debt, equity and preference capital in different

proportions, or

Page � of �13 55


f) Use a combination of debt and preference capital in different proportion (in case of existing company).

Note: The choice of the combination of these sources is called capital structure mix.

25.While choosing a suitable financing pattern, certain fundamental principles should be kept in minds, to design capital structure. Mention and briefly explain those fundamental principles.

Answer: The fundamental principles have been explained below:

1. Financial leverage of Trading on Equity: ✓ The use of long-term fixed interest bearing debt and preference

share capital along with equity share capital is called financial leverage or trading on equity.

✓ The use of long-term debt increases the earnings per share if the firm yields a return higher than the cost of debt.

✓ The earnings per share also increase with the use of preference share capital but due to the fact that interest is allowed to be deducted while computing tax, the leverage impact of debt is much more.

✓ However, leverage can operate adversely also if the rate of interest on long-term loan is more than the expected rate of earnings of the firm.

✓ Therefore, it needs caution to plan the capital structure of a firm. 2. Growth and stability of sales: ✓ The capital structure of a firm is highly influenced by the growth

and stability of its sale. ✓ If the sales of a firm are expected to remain fairly stable, it can

raise a higher level of debt. ✓ Similarly, the rate of the growth in sales also affects the capital

structure decision. ✓ Usually, greater the rate of growth of sales, greater can be the use

of debt in the financing of firm.

Page � of �14 55


✓ On the other hand, if the sales of a firm are highly fluctuating or declining, it should not employ, as far as possible, debt financing in its capital structure.

3. Cost Principle: ✓ According to this principle, an ideal pattern or capital structure is

one that minimizes cost of capital structure and maximizes earnings per share (EPS).

✓ For e.g. Debt capital is cheaper than equity capital from the point of its cost and interest being deductible for income tax purpose, whereas no such deduction is allowed for dividends.

4. Risk Principle: ✓ According to this principle, reliance is placed more on common

equity for financing capital requirements than excessive use of debt.

✓ Use of more and more debt means higher commitment in form of interest payout.

✓ This would lead to erosion of shareholders’ value in unfavorable business situation.

✓ There are two risks associated with this principle: i. Business risk: ➢ It is an unavoidable risk because of the environment in

which the firm has to operate and it is represented by the variability of earnings before interest and tax (EBIT).

➢ The variability in turn is influenced by revenues and expenses.

➢ Revenues and expenses are affected by demand of firm products, variations in prices and proportion of fixed cost in total cost.

ii. Financial risk: ➢ It is a risk associated with the availability of earnings

per share caused by use of financial leverage. ➢ It is the additional risk borne by the shareholders when

a firm uses debt in addition to equity financing. ➢ Generally, a firm should neither be exposed to high

degree of business risk and low degree of financial risk

Page � of �15 55


or vice-versa, so that shareholders do not bear a higher risk.

5. Control Principle: ✓ While designing a capital structure, the finance manager may also

keep in mind that existing management control and ownership remains undisturbed.

✓ Issue of new equity will dilute existing control pattern and also it involves higher cost.

✓ Issue of more debt causes no dilution in control, but causes a higher degree of financial risk.

6. Flexibility Principle: ✓ By flexibility it means that the management chooses such a

combination of sources of financing which it finds easier to adjust according to changes in need of funds in future too.

✓ While debt could be interchanged (If the company is loaded with a debt of 18% and funds are available at 15%, it can return old debt with new debt, at a lesser interest rate), but the same option may not be available in case of equity investment.

7. Other Consideration: ✓ Besides above principles, other factors such as nature of industry,

timing of issue and competition in the industry should also be considered.

✓ Industries facing severe competition also resort to more equity than debt.

26.Briefly explain the key concepts for designing optimal structure. Answer:

✓ The capital structure decisions influence debt–equity mix which ultimately affects shareholder’s return and risk.

✓ Since cost of debt is cheaper, firm prefers to borrow rather than to raise money from equity. So long as return on investment is more than the cost of borrowing, extra borrowing increases the earnings per share.

✓However, beyond a limit, it increases the risk and share price may fall because shareholders may assume that their investment is associated with more risk.

Page � of �16 55


✓ The major key concepts for designing optimal structure is explained as below:

a. Leverages: ✓ There are two leverages associated with the study of capital

structure, namely operating leverage and financial leverage. ✓However, the determination of optimal level of debt is a

formidable task and is a major policy decision which involves equalizing between return and risk.

✓ EBIT-EPS analysis is a widely used tool to determine level of debt in a firm.

✓ Through this analysis, a comparison can be drawn for various methods of financing by obtaining indifference point.

✓ It is a point to the EBIT level at which EPS remains unchanged irrespective of level of debt-equity mix.

b. Coverage Ratio: ✓ The ability of the firm to use debt in the capital structure can

also be judged in terms of coverage ratio namely EBIT/Interest.

✓Higher the ratio, greater is the certainty of meeting interest payments.

c. Cash flow Analysis: ✓ To determine the debt capacity, cash flow under adverse

conditions should be examined. ✓A high debt equity ratio is not risky if the company has the

ability to generate cash flows. ✓ It would, therefore, be possible to increase the debt until cash

flows equal the risk set out by debt. ✓ The main drawback of this approach is that it fails to take

into account uncertainty due to technological developments or changes in political climate.

Note: ✓ These approaches as discussed above do not provide solution to the

problem of determining an appropriate level of debt. ✓ However, with the information available a range can be determined for

an optimum level of debt in the capital structure.

Page � of �17 55


27.Mention the essential features of a sound capital mix. Answer: A sound or an appropriate capital structure should have the following essential features:

a. Maximum possible use of leverage. b. The capital structure should be flexible. c. To avoid undue financial/business risk with the increase of debt. d. The use of debt should be within the capacity of a firm. The firm

should be in a position to meet its obligation in paying the loan and interest charges as and when due.

e. It should involve minimum possible risk of loss of control. f. It must avoid undue restrictions in agreement of debt. g. The capital structure should be conservative. It should be composed of

high grade securities and debt capacity of the company should never be exceeded.

h. The capital structure should be simple in the sense that it can be easily managed and also easily understood by the investors.

i. The debt should be used to the extent that it does not threaten the solvency of the firm.

28.Briefly explain the meaning of optimal capital structure. Also explain why it is important to select optimal capital structure.

Answer: ✓ The theory of optimal capital structure deals with the issue of the right

mix of debt and equity in the long term capital structure of a firm. ✓ This theory states that if a company takes on debt, the value of the firm

increases up to a point. ✓ Beyond that point if debt continues to increase then the value of the

firm will start to decrease. ✓Also, if the company is unable to repay the debt within the specified

period then it will affect the goodwill of the company and may create problems for collecting further debt.

✓ Therefore, the company should select its appropriate capital structure with due consideration to the other factors.

Page � of �18 55


29.Briefly why EBIT-EPS analysis is important while designing optimal capital structure.

Answer: ✓ EBIT-EPS analysis is a vital tool for designing the optimal capital

structure of a company. ✓ The main objective of this analysis is to find the EBIT level that will

equate EPS regardless of the financing plan chosen. ✓ The financial leverage affects the pattern of distribution of operating

profit among various types of investors and increases the variability of the EPS of the firm.

✓ Therefore, while searching for an appropriate capitals structure for a firm, the financial manager must analyze the effects of various alternative financial leverages on the EPS.

✓ The effect of leverage on the EPS emerges because of the existence of fixed financial charge (i.e., interest on debt and fixed dividend on preference share capital).

30.Explain how the effect of fixed financial charge on the EPS depends upon the relationship between the rate of return on assets and the rate of fixed charge.

Answer: The effect of fixed financial charge on the EPS extensively depends upon the relationship between the rate of return on assets and the rate of fixed charge, which has been explained in the following points:

✓ If the rate of return on assets is higher than the cost of financing, then the increasing use of fixed charge financing (i.e., debt and preference share capital) will result in increase in the EPS.

✓ This situation is also known as favorable financial leverage or Trading on Equity.

✓On the other hand, if the rate of return on assets is less than the cost of financing, then the effect may be negative and, therefore, the increasing use of debt and preference share capital may reduce the EPS of the firm.

Page � of �19 55


31.Briefly explain the reasons why the choice is jilted in favor of debt financing, while choosing between debt financing and issue of preference shares at the time of deciding fixed financial charge financing.

Answer: ✓ The fixed financial charge financing may further be analyzed with

reference to the choice between the debt financing and the issue of preference shares.

✓ Theoretically, the choice is tilted in favor of debt financing for two reasons:

i. The explicit cost of debt financing i.e., the rate of interest payable on debt instruments or loans is generally lower than the rate of fixed dividend payable on preference shares, and

ii. Interest on debt financing is tax-deductible and therefore the real cost (after-tax) is lower than the cost of preference share capital.

32.Explain the concept of Financial Break-even and Indifference Analysis. Answer:

A. Financial break-even: ✓ Financial break-even point is the minimum level of EBIT needed

to satisfy all the fixed financial charges i.e. interest and preference dividends.

✓ It denotes the level of EBIT for which the company’s EPS equals zero.

✓ If the EBIT is less than the financial breakeven point, then the EPS will be negative.

✓ But if the expected level of EBIT is more than the breakeven point, then more fixed costs financing instruments can be taken in the capital structure, otherwise, equity would be preferred.

B. Indifference Analysis: ✓ One method of considering the impact of various financing

alternatives on earnings per share is to prepare the EBIT chart or the range of Earnings Chart.

Page � of �20 55


✓ This chart shows the likely EPS at various probable EBIT levels. ✓ The EPS may go down if another alternative of financing is

chosen even though the EBIT remains at the same level. ✓ At a given EBIT, earnings per share under various alternatives of

financing may be plotted. ✓ A straight line representing the EPS at various levels of EBIT

under the alternative may be drawn. ✓ Wherever this line intersects, it is known as break-even point. ✓ This is known as EPS equivalency point or indifference point

since this shows that, between the two given alternatives of financing (i.e., regardless of leverage in the financial plans), EPS would be the same at the given level of EBIT.

33.Write down the algebraic formula used to find out the equivalency or indifference point.

Answer: The equivalency or indifference point can also be calculated algebraically in the following manner:

!

Where, EBIT = Indifference Point ! = Number of equity shares in Alternative 1 ! = Number of equity shares in Alternative 1 ! = Interest charges in Alternative 1 ! = Interest charges in Alternative 2

(EBIT − 11)(1 − T)E1

=(EBIT − 12)(1 − T)

E2

E1E11112

Page � of �21 55


Alternative 1 = All Equity Finance Alternative 2 = Debt-equity Finance

34.What are the limitations of EBIT-EPS Analysis? Answer:

✓ If maximization of the EPS is the only criterion for selecting the particular debt-equity mix, then that capital structure which is expected to result in the highest EPS will always be selected by all the firms. However, achieving the highest EPS need not be the only goal of the firm.

✓ The main shortcomings of the EBIT-EPS analysis may be noted as follows:

i. The EPS criterion ignores the risk dimension: ➢ The EBIT-EPS analysis ignores as to what is the effect of

leverage on the overall risk of the firm. ➢ With every increase in financial leverage, the risk of the firm

and therefore that of investors also increases. ➢ The EBIT-EPS analysis fails to deal with the variability of

EPS and the risk return trade-off. ii. EPS is more of a performance measure: ➢ The EPS, basically, depends upon the operating profit which,

in turn, depends upon the operating efficiency of the firm. ➢ It is a resultant figure and it is more a measure of

performance rather than a measure of decision making.

35.Explain how financial leverage can largely influence the value of the firm through the cost of capital.

Answer: ✓ The financial leverage has a magnifying effect on earnings per share,

such that for a given level of percentage increase in EBIT, there will be more than proportionate change in the same direction in the earnings per share.

✓ The financing decision of the firm is one of the basic conditions oriented to the achievement of maximization for the shareholders’ wealth.

Page � of �22 55


✓ The capital structure should be selected in such a way that it not only maximizes the value of the company and wealth of its owners, but also minimizes the cost of capital.

✓As a result, the company is able to increase its economic rate of investment and growth.

✓ It is important to note that while financing mix cannot affect the total earnings, it can affect the share of earnings belonging to the shareholders.

36.Explain the concept of over-capitalization & under-capitalization. Answer:

A. Over-capitalization: ✓ It is a situation where a firm has more capital than it needs or in

other words assets are worth less than its issued share capital, and earnings are insufficient to pay dividend and interest.

✓ This situation mainly arises when the existing capital is not effectively utilized on account of fall in earning capacity of the company while company has raised funds more than its requirements.

✓ The chief sign of over-capitalization is the fall in payment of dividend and interest leading to fall in value of the shares of the company.

B. Under-Capitalization: ✓ It is just reverse of over-capitalization. ✓ It is a state, when its actual capitalization is lower than its proper

capitalization as warranted by its earning capacity. ✓ This situation normally happens with companies which have

insufficient capital but large secret reserves in the form of considerable appreciation in the values of the fixed assets not brought into the books.

Page � of �23 55


37.Explain briefly the consequences of over-capitalization & under-capitalization.

Answer: A. Consequences of Over-Capitalization:

i. Considerable reduction in the rate of dividend and interest payments.

ii. Reduction in the market price of shares. iii. Resorting to “window dressing”. iv. Some companies may opt for reorganization. However, sometimes

the matter gets worse and the company may go into liquidation. B. Consequences of Under-Capitalization:

i. The dividend rate will be higher in comparison to similarly situated companies.

ii. Market value of shares will be higher than value of shares of other similar companies because their earning rate being considerably more than the prevailing rate on such securities.

iii. Real value of shares will be higher than their book value.

38.Mention the causes of over-capitalization. Answer: Over-capitalization arises due to following reasons:

i. Raising more money through issue of shares or debentures than company can employ profitably.

ii. Borrowing huge amount at higher rate than rate at which company can earn.

iii. Excessive payment for the acquisition of fictitious assets such as goodwill etc.

iv. Improper provision for depreciation, replacement of assets and distribution of dividends at a higher rate.

v. Wrong estimation of earnings and capitalization.

39.What are the possible remedies in case over-capitalization & under-capitalization occurs?

Answer: A. Remedies in case over-capitalization:

Page � of �24 55


Following steps may be adopted to avoid the negative consequences of over-capitalization:

i. Company should go for thorough reorganization. ii. Buyback of shares. iii. Reduction in claims of debenture-holders and creditors. iv. Value of shares may also be reduced. This will result in sufficient

funds for the company to carry out replacement of assets. B. Remedies in case under-capitalization:

Following steps may be adopted to avoid the negative consequences of under capitalization:

i. The shares of the company should be split up. This will reduce dividend per share, though EPS shall remain unchanged.

ii. Issue of Bonus Shares is the most appropriate measure as this will reduce both dividend per share and the average rate of earning.

iii. By revising upward the par value of shares in exchange of the existing shares held by them.

40.Mention the effects of under-capitalization. Answer: Under-capitalization has the following effects:

i. It encourages acute competition. High profitability encourages new entrepreneurs to come into same type of business.

ii. High rate of dividend encourages the workers’ union to demand high wages.

iii. Normally common people (consumers) start feeling that they are being exploited.

iv. Management may resort to manipulation of share values. v. Invite more government control and regulation on the company and

higher taxation also.

41.Explain over-capitalization vis-a-vis under-capitalization. Answer:

✓ Both over capitalisation and under capitalisation are not good. ✓However, over capitalisation is more dangerous to the company,

shareholders and the society than under capitalisation.

Page � of �25 55


✓ The situation of under capitalisation can be handled more easily than the situation of over-capitalisation.

✓Moreover, under capitalisation is not an economic problem but a problem of adjusting capital structure.

✓ Thus, under capitalisation should be considered less dangerous but both situations are bad and every company should strive to have a proper capitalisation.

Page � of �26 55


Practical Questions

1. Masco Limited wishes to raise additional finance of ₹10 lakhs for

meeting its investment plans. It has ₹2, 10,000 in the form of retained

earnings available for investment purposes. Further details are as

following:

You are required:

a) To determine the pattern for raising the additional finance.

b) To determine the post-tax average cost of additional debt.

c) To determine the cost of retained earnings and cost of equity, and

d) Compute the overall weighted average after tax cost of additional finance.

Page � of �27 55

Debt/equity mix 30%/70%

Cost of debt

Up to ₹1,80,000 10% (before tax)

Beyond ₹1,80,000 16% (before tax)

Earnings per share ₹4

Dividend pay out 50% of earnings

Expected growth rate in dividend 10%

Current market price per share ₹44

Tax Rate 50%


2. Best of Luck Ltd., a profit making company, has a paid-up capital of

₹100 lakhs consisting of 10 lakhs ordinary shares of ₹10 each.

Currently, it is Earnings an annual pre-tax profit of ₹60 lakhs. The

company's shares are listed and are quoted in the range of ₹50 to ₹80.

The management wants to diversify production and has approved a

project which will cost ₹50 lakhs and which is expected to yield a pre-

tax income of ₹40 lakhs per annum. To raise this additional capital, the

following options are under consideration of the management:

(a) To issue equity share capital for the entire additional amount. It is

expected that the new shares (face value of ₹10) can be sold at a

premium of ₹15.

(b) To issue 16% non-convertible debentures of ₹100 each for the entire

amount.

(c) To issue equity capital for ₹25 lakhs (face value of ₹10) and 16% non-

convertible debentures for the balance amount. In this case, the

company can issue shares at a premium of ₹40 each.

You are required to advise the management as to how the additional capital

can be raised, keeping in mind that the management wants to maximise the

Earnings per share to maintain its goodwill. The company is paying income

tax at 50%. (SM)

Page � of �28 55


3. Ganesha Limited is setting up a project with a capital outlay of

₹60,00,000. It has two alternatives in financing the project cost.

Alternative-I: 100% equity finance by issuing equity shares of ₹10

each

Alternative-II: Debt-equity ratio 2:1(equity shares will be of ₹10 each)

The rate of interest payable on the debts is 18% p.a. The corporate tax rate is

40%. Calculate the indifference point between the two alternative methods

of financing. (SM)

4. Ganapati Limited is considering three financing plans. The key information is as follows:

(a) Total investment to be raised ₹2,00,000

(b) Plans of Financing Proportion:

(c) Cost of debt 8%

Cost of preference shares 8%

(d) Tax rate 50%

(e) Equity shares of the face value of ₹10 each will be issued at a premium

of ₹10 per share.

Plans Equity Debt P r e f e r e n c e

SharesA 100% - -

B 50% 50% -

C 50% - 50%

Page � of �29 55


(f) Expected EBIT is ₹80,000.

You are required to determine for each plan: -

(i) Earnings per share (EPS)

(ii) The financial break-even point.

(iii) Indicate if any of the plans dominate and compute the EBIT range

among the plans for indifference. (SM)

5. Shahji Steels Limited requires ₹25,00,000 for a new plant. This plant is

expected to yield Earnings before interest and taxes of ₹5,00,000.

While deciding about the financial plan, the company considers the

objective of maximizing Earnings per share. It has three alternatives to

finance the project - by raising debt of ₹2,50,000 or ₹10,00,000 or

₹15,00,000 and the balance, in each case, by issuing equity shares. The

company's share is currently selling at ₹150, but is expected to decline to

₹125 in case the funds are borrowed in excess of ₹10,00,000. The funds can

be borrowed at the rate of 10 percent upto ₹2,50,000, at 15 percent over

₹2,50,000 and upto ₹10,00,000 and at 20 percent over ₹10,00,000. The tax

rate applicable to the company is 50 percent. Which form of financing

should the company choose? (SM)

Page � of �30 55


6. Yoyo Limited presently has ₹36,00,000 in debt outstanding bearing an

interest rate of 10 per cent. It wishes to finance a ₹40,00,000 expansion

programme and is considering three alternatives: additional debt at 12 per cent interest, preference shares with an 11 per cent dividend, and

the issue of equity shares at ₹16 per share. The company presently has

8,00,000 shares outstanding and is in a 40 per cent tax bracket.

(a) If Earnings before interest and taxes are presently ₹15,00,000, what

would be Earnings per share for the three alternatives, assuming no

immediate increase in profitability?

(b) Develop an indifference chart for these alternatives. What are the

approximate indifference points? To check one of these points, what is

the indifference point mathematically between debt and common?

(c) Which alternative do you prefer? How much would EBIT need to

increase before the next alternative would be best? (SM)

7. Alpha Limited requires funds amounting to ₹80 lakh for its new

project. To raise the funds, the company has following two alternatives:

(i) to issue Equity Shares of ₹100 each (at par) amounting to ₹60 lakh and

borrow the balance amount at the interest of 12% p.a.; or

(ii) to issue Equity Shares of ₹100 each (at par) and 12% Debentures in

equal proportion. The Income-tax rate is 30%.

Find out the point of indifference between the available two modes of

financing and state which option will be beneficial in different situations.

(SM)

Page � of �31 55


8. Alpha Limited and Beta Limited are identical except for capital

structures. Alpha Ltd. has 50 per cent debt and 50 per cent equity,

whereas Beta Ltd. has 20 per cent debt and 80 per cent equity. (All percentages are in market-value terms). The borrowing rate for both

companies is 8 per cent in a no-tax world, and capital markets are

assumed to be perfect.

(a) (i) If you own 2 per cent of the shares of Alpha Ltd., what is your return

if the company has net operating income of ₹3,60,000 and the overall

capitalisation rate of the company, K0 is 18 per cent? (ii) What is the

implied required rate of return on equity?

(b) Beta Ltd. has the same net operating income as Alpha Ltd. (i) What is

the implied required equity return of Beta Ltd.? (ii) Why does it differ

from that of Alpha Ltd.? (SM)

9. Rupa Ltd.’s EBIT is ₹5,00,000. The company has 10%, 20 lakh

debentures. The equity capitalization rate i.e. Ke is 16%.

You are required to calculate:

(i) Market value of equity and value of firm

(ii) Overall cost of capital.

(SM)

Page � of �32 55


10. Calculate the level of Earnings before interest and tax (EBIT) at which

the EPS indifference point between the following financing alternatives

will occur.

(i) Equity share capital of ₹6,00,000 and 12% debentures of ₹4,00,000.Or

(ii) Equity share capital of ₹4,00,000, 14% preference share capital of

₹2,00,000 and 12% debentures of ₹4,00,000.

Assume the corporate tax rate is 35% and par value of equity share is ₹10

in each case. (PM)

11. A new project is under consideration in Zip Ltd., which requires a capital

investment of ₹4.50 crores. Interest on term loan is 12% and Corporate

Tax rate is 50%. If the Debt Equity ratio insisted by the financing agencies is 2: 1, calculate the point of indifference for the project.(PM)

12. RES Ltd. is an all equity financed company with a market value of

₹25,00,000 and cost of equity (Ke) 21%. The company wants to buyback

equity shares worth ₹5,00,000 by issuing and raising 15% perpetual

debt of the same amount. Rate of tax may be taken as 30%. After the capital restructuring and applying MM Model (with taxes), you are

required to calculate:

(i) Market value of RES Ltd.

(ii) Cost of Equity (Ke)

(iii) Weighted average cost of capital (using market weights) and comment

on it.(PM)

Page � of �33 55


13. D Ltd. is foreseeing a growth rate of 12% per annum in the next two

years. The growth rate is likely to be 10% for the third and fourth year.

After that the growth rate is expected to stabilise at 8% per annum. If

the last dividend was ₹1.50 per share and the investor’s required rate of

return is 16%, determine the current value of equity share of the company. The P.V. factors at 16%

(PM)

14. A Company earns a profit of ₹3,00,000 per annum after meeting its

Interest liability of ₹1,20,000 on 12% debentures. The Tax rate is 50%.

The number of Equity Shares of ₹10 each are 80,000 and the retained

Earnings amount to ₹12,00,000. The company proposes to take up an

expansion scheme for which a sum of ₹4,00,000 is required. It is

anticipated that after expansion, the company will be able to achieve the

same return on investment as at present. The funds required for

expansion can be raised either through debt at the rate of 12% or by

issuing Equity Shares at par.

Required:

(i) Compute the Earnings per Share (EPS), if:

➢ The additional funds were raised as debt

➢ The additional funds were raised by issue of equity shares.

(ii) Advise the company as to which source of finance is preferable. (PM)

Year 1 2 3 4

P.V. Factor 0.862 0.743 0.641 0.552

Page � of �34 55


15. A Ltd. and B Ltd. are identical in every respect except capital structure.

A Ltd. does not employ debts in its capital structure whereas B Ltd.

employs 12% Debentures amounting to ₹10 lakhs. Assuming that:

(i) All assumptions of M-M model are met;

(ii) Income-tax rate is 30%;

(iii) EBIT is ₹2,50,000 and

(iv) The Equity capitalization rate of ‘A' Ltd. is 20%.

Calculate the value of both the companies and also find out the Weighted

Average Cost of Capital for both the companies.(PM)

16. A Company needs ₹31,25,000 for the construction of a new plant. The

following three plans are feasible:

I. The Company may issue 3,12,500 equity shares at ₹10 per share.

II. The Company may issue 1,56,250 equity shares at ₹10 per share and

15,625 debentures of ₹100 denomination bearing a 8% rate of interest.

III. The Company may issue 1,56,250 equity shares at ₹10 per share and

15,625 cumulative preference shares at ₹100 per share bearing a 8%

rate of dividend.

(i) if the Company's Earnings before interest and taxes are ₹62,500,

₹1,25,000, ₹2,50,000, ₹3,75,000 and ₹6,25,000, what are the

Earnings per share under each of three financial plans ? Assume a

Corporate Income tax rate of 40%.

(ii) Which alternative would you recommend and why?

(iii) Determine the EBIT-EPS indifference points by formulae between

Financing Plan I and Plan II and Plan I and Plan III. (PM

Page � of �35 55


17. A firm has sales of ₹75,00,000 variable cost is 56% and fixed cost is

₹6,00,000. It has a debt of ₹45,00,000 at 9% and equity of ₹55,00,000.

(i) What is the firm’s ROI?

(ii) Does it have favourable financial leverage?

(iii) If the firm belongs to an industry whose capital turnover is 3, does it

have a high or low capital turnover?

(iv) What are the operating, financial and combined leverages of the firm?

(v) If the sales is increased by 10% by what percentage EBIT will

increase?

(vi) At what level of sales the EBT of the firm will be equal to zero?

(vii) If EBIT increases by 20%, by what percentage EBT will increase?

(PM, RTP, Nov 2017, Nov 2018)

18. X Ltd. is considering the following two alternative financing plans:

(₹)

The indifference point between the plans is ₹2,40,000. Corporate tax rate is

30%. Calculate the rate of dividend on preference shares.

(Nov-13, 5 Marks, PM)

Plan-I Plan-II

Equity shares of ₹10 each 4,00,000 4,00,000

12% Debentures 2,00,000 -

Preference Shares of ₹100 each - 2,00,000

Total: 6,00,000 6,00,000

Page � of �36 55


19. 'A' Ltd. and 'B' Ltd. are identical in every respect except capital

structure. 'A' Ltd. does not employ debts in its capital structure whereas

'B' Ltd. employs 12% Debentures amounting to ₹10 lakhs. Assuming

that:

(i) All assumptions of M-M model are met;

(ii) Income-tax rate is 30%;

(iii) EBIT is ₹2,50,000 and

(iv) The Equity capitalization rate of ‘A' Ltd. is 20%.

Calculate the value of both the companies and also find out the Weighted

Average Cost of Capital for both the companies.

(Nov-14, 5 Marks)

20. RST Ltd is expecting an EBIT of ₹4 lakhs for F.Y. 2015-16. Presently the

company is financed entirely by equity share capital of ₹20 lakhs with

equity capitalization rate of 16%. The company is contemplating to

redeem part of the capital by introducing debt financing. The company has two options to raise debt to the extent of 30% or 50% of the total

fund.

It is expected that for debt financing upto 30%, the rate of interest will be

10% and equity capitalization rate will increase to 17%. If the company opts

for 50% debt, then the interest rate will be 12% and equity capitalization rate

will be 20%.

You are required to compute value of the company; its overall cost of capital

under different options and also state which is the best option.(Nov-15, 8

Marks)

Page � of �37 55


21. India Limited requires ₹50,00,000 for a new plant. This Plant is expected

to yield Earnings before interest and taxes of ₹10,00,000.

While deciding about the financial plan, the company considers the objective

of maximizing Earnings per share. It has three alternatives to finance the

project- by raising debt of ₹5,00,000 or ₹20,00,000 or ₹30,00,000 and the

balance, in each case, by issuing equity shares. The company’s share is

currently selling at ₹150, but is expected to decline to ₹125 in case the funds

are borrowed in excess of ₹20,00,000. The funds can be borrowed at the rate

of 9 percent upto ₹5,00,000, at 14 percent over ₹5,00,000 and upto

₹20,00,000 and at 19 percent over ₹20,00,000. The tax rate applicable to the

company is 40 percent. Which form of financing should company choose?

Show EPS Amount upto two decimal points. (Nov-16, 8 Marks)

22. PNR Limited and PXR Limited are identical in every respect except capital structure. PNR limited does not employ debts in its capital

structure whereas PXR Limited employs 12% Debentures amounting to

₹20,00,000. The following additional information are given to you:

(i) Income tax rate is 30%

(ii) EBIT is ₹5,00,000

(iii) The equity capitalization rate of PNR Limited is 20% and

(iv) All assumptions of Modigliani - Miller Approach are met.

Calculate:

(a) Value of both the companies,

(b) Weighted average cost of capital for both the companies. (May-17, 8

Marks)

Page � of �38 55


23. The X Ltd. is willing to raise funds for its new project which requires an

investment of ₹84 lakhs. The company has two options:

Option I : To issue Equity Shares (₹10 each) only

Option II : To avail term loan at an interest rate of 12%. But in this

case, as insisted by the financing agencies, the company will have to maintain

a debt equity proportion of 2:1.

The corporate tax rate is 30%.

Find out the point of indifference for the project.(Nov-17, 5 Marks)

24. The following current data are available concerning Theta Limited: Share issued 10,000

Market price per share ₹20

Interest rate 12%

Tax Rate 46%

Expected EBIT ₹15,000

The company requires an additional ₹50,000 for the coming year.

You are required to determine:

(i) Which financing option (debt or equity issue) will give higher EPS for

the expected EBIT?

(ii) What is indifference level of EBIT for the two alternatives?

(iii) What is EPS for that EBIT?(RTP, Nov 2013)

Page � of �39 55


25. The following figures of Theta Limited are presented as under:

The company has undistributed reserves and surplus of ₹20 lakhs. It is in need

of ₹30 lakhs to pay off debentures and modernise its plants. It seeks your

advice on the following alternative modes of raising finance.

Alternative 1 - Raising entire amount as term loan from banks @ 12%.

Alternative 2 - Raising part of the funds by issue of 1,00,000 shares of ₹20

each and the rest by term loan at 12 percent.

The company expects to improve its rate of return by 2 percent as a result of

modernisation, but P/E ratio is likely to go down to 8 if the entire amount is

raised as term loan.

(i) Advise the company on the financial plan to be selected.

₹Earnings before Interest and Tax 23,00,000

Less: Debenture Interest @ 8% 80,000

Long Term Loan Interest @ 11% 2,20,000 3,00,000

20,00,000

Less: Income Tax 10,00,000

Earnings after tax 10,00,000

No. of Equity Shares of ₹10 each

EPS

Market Price of Share

P/E Ratio

5,00,000

₹2

₹20

10

Page � of �40 55


(ii) If it is assumed that there will be no change in the P/E ratio if either of

the two alternatives is adopted, would your advice still hold good?

(RTP, May 2014)

26. The following is an extract from the financial statements of Zeta Limited:

The market price per equity share is ₹12 and per debenture is ₹93.75. You are

required to calculate:

(a) The Earnings per share.

(b) The percentage cost of capital to the company for debentures and the

equity. (RTP, May 2014)

Amount (₹lakhs)

Operating Profit

Less: Interest on Debentures

Earnings before Taxes

Less: Income Tax (35%)

Earnings after Taxes

Equity Share Capital (shares of ₹10 each)

Reserves and Surplus

15% Non-Convertible Debentures (of ₹100 each)

105.0

33.0

72.0

25.2

46.8

200.0

100.0

220.0

520.0

Page � of �41 55


27. Theta Limited has a total capitalization of ₹10 Lakhs consisting entirely

of equity shares of ₹50 each. It wishes to raise another ₹5 lakhs for

expansion through one of its two possible financial plans.

(1) All equity shares of ₹50 each.

(2) All debentures carrying 9% interest.

The present level of EBIT is ₹1,40,000 and Income tax rate is 50%.

Calculate EBIT level at which Earnings per share would remain the same

irrespective of raising funds through equity shares or debentures.

(RTP, Nov 2014)

28. Akash Limited provides you the following information:

(₹)

Profit (EBIT)

Less: Interest on Debenture @ 10%

EBT

Less Income Tax @ 50%

No. of Equity Shares ( ₹10 each)

Earnings per share (EPS)

Price /EPS (PE) Ratio

2,80,000

40,000

2,40,000

1,20,000

1,20,000

30,000

4

10

Page � of �42 55


The company has reserves and surplus of ₹7,00,000 and required ₹4,00,000

further for modernisation. Return on Capital Employed (ROCE) is constant.

Debt (Debt/ Debt + Equity) Ratio higher than 40% will bring the P/E Ratio

down to 8 and increase the interest rate on additional debts to 12%. You are

required to ascertain the probable price of the share.

(i) If the additional capital are raised as debt; and

(ii) If the amount is raised by issuing equity shares at ruling market price.

(RTP, May 2016, Nov2017)

29. M/s. Sensation Corporation has a capital structure of 40% debt and 60%

equity. The company is presently considering several alternative

investment proposals costing less than ₹20 lakhs. The corporation always

raises the required funds without disturbing its present debt equity ratio.

The cost of raising the debt and equity are as under:

Assuming the tax rate at 50% calculate:-

(i) Cost of capital of two projects X and Y whose fund requirements are

₹6.5 lakhs and ₹14 lakhs respectively.

(ii) If a project is expected to give after tax return of 10% determine under

what conditions it would be acceptable? (RTP, Nov 2016, Nov 2018)

Project Cost Cost of debt Cost of equity

Upto ₹2 lakhs

Above ₹2 lakhs & upto to ₹5 lakhs

Above ₹5 lakhs & upto ₹10 lakhs

Above ₹10 lakhs & upto ₹20 lakhs

10%

11%

12%

13%

12%

13%

14%

14.5%

Page � of �43 55


30. J Ltd. is an all equity financed company with a market value of

₹25,00,000 and cost of equity (Ke) 21%. The company wants to buyback

equity shares worth ₹5,00,000 by issuing and raising 15% perpetual debt

of the same amount. Rate of tax may be taken as 30%. After the capital

restructuring and applying MM Model (with taxes), you are required to

calculate: (i) Market value of J Ltd.

(ii) Cost of Equity (Ke)

(iii) Weighted average cost of capital (using market weights) and comment

on it.

(RTP, Nov 2016, Nov 2018)

31. Company P and Q are identical in all respects including risk factors

except for debt/equity, company P having issued 10% debentures of ₹18

lakhs while company Q is unlevered. Both the companies earn 20%

before interest and taxes on their total assets of ₹30 lakhs.

Assuming a tax rate of 50% and capitalization rate of 15% from an all-equity

company. Compute the value of companies P and Q using (i) Net Income

Approach and (ii) Net Operating Income Approach.

(RTP, Nov 2015, May 2018)

Page � of �44 55


32. A Company needs ₹31,25,000 for the construction of a new plant. The

following three plans are feasible:

I. The Company may issue 3,12,500 equity shares at ₹10 per share.

II. The Company may issue 1,56,250 equity shares at ₹10 per share and

15,625 debentures of ₹100 denomination bearing an 8% rate of interest.

III. The Company may issue 1,56,250 equity shares at ₹10 per share and

15,625 preference shares at ₹100 per share bearing an 8% rate of

dividend.

(i) If the Company's Earnings before interest and taxes are ₹62,500,

₹1,25,000, ₹2,50,000, ₹3,75,000 and ₹6,25,000, what are the Earnings

per share under each of three financial plans? Assume a Corporate

Income tax rate of 40%.

(ii) Which alternative would you recommend and why?

(iii) Determine the EBIT-EPS indifference points by formulae between

Financing Plan I and Plan II and Plan I and Plan III.

(RTP, May 2017)

Page � of �45 55


33. X Ltd. a widely held company is considering a major expansion of its

production facilities and the following alternatives are available:

Expected rate of return before tax is 25%. The rate of dividend of the

company is not less than 20%. The company at present has low debt.

Corporation tax rate is 50%. Which of the alternatives you would choose?

34. The following figures are made available to you:

The company has accumulated revenue reserves of ₹12 lakhs. The company is

examining a project calling for an investment obligation of ₹10 lakhs; this

investment is expected to earn the same rate of return as funds already

Alternative (₹in lakhs)

A B C

Share Capital 50 20 10

14% Debentures -- 20 15

18% Loan -- 10 25

₹Net Profits for the year 18,00,000

Less: Interest on secured debentures at 15% p.a.

(Debentures were issued 3 months after the

commencement of the year)

1,12,500

16,87,500

Less: Income Tax at 35% and dividend distribution tax 8,43,750

Profit after tax 8,43,750

Number of Equity shares (₹10 each) 1,00,000

Market quotation of equity share ₹109.70

Page � of �46 55


employed. You are informed that a debt equity ratio higher than 45% will

cause the price Earnings ratio to come down by 25% and the interest rate on

additional borrowings on secured debentures. You are required to advise the

company on the probable price of the equity share, if

(a) the additional investment were to be raised by way of loans; or

(b) the additional investment were to be raised by way of equity.

35. MP Ltd. needs ₹20,00,000 for expansion. The expansion is expected to

yield an annual EBIT of 16%. In choosing a financial plan, MP Ltd. has a objective of maximising Earnings per share.

It is considering the possibility of issuing equity shares and raising debt of

₹2,00,000 or ₹8,00,000 or ₹12,00,000. The current market price per share is

₹50 and is expected to drop to ₹40 if the funds are borrowed in excess of

₹10,00,000. Funds can be borrowed at the rates indicated below:

(a) Upto ₹2,00,000 at 8%.

(b) Over ₹2,00,000 and upto ₹10,00,000 at 12%.

(c) Over ₹10,00,000 at 18%. Assume tax rate of 40%.

Required: Determine the EPS for the three financing alternatives.

Page � of �47 55


36. A company's capital structure consists of the following:

The company earns 12% on its capital. The income-tax rate is 40%. The

company requires a sum of ₹25 lakh to finance its expansion program for

which following alternatives are available to it:

(i) Issue of 20,000 Equity Shares at a premium of ₹25 per share.

(ii) Issue of 10% Preference Shares.

(iii) Issue of 8% Debentures.

It is estimated that the P/E ratios in the cases of Equity, Preference and

Debenture financing would be 21.4,17 and 15.7 respectively.

Required: Which of the three financing alternatives would you recommend

and why?

37. The Evergrowing Company has to decide between debt fund and equity

for its expansion programme. Its current position is as follows:

Equity shares of ₹100 each ₹20,00,000

Retained Earnings ₹10,00,000

9% Preference Shares ₹12,00,000

7% Debentures ₹8,00,000

Total ₹50,00,000

Particulars ₹5% Debt 40,000

Equity capital (₹10 per share) 1,00,000

Surplus 60,000

Total Capitalization 2,00,000

Sales 6,00,000

Less: Total Cost 5,38,000

Page � of �48 55


The expansion programme is estimated to cost 1,00,000. If this is financed

through debt, the rate of new debt will be 7% and the price Earnings ratio will

be 6 times. If the expansion programme is financed through equity shares, the

new shares can be sold net at 25 per share and the price to Earnings ratio will

be 7 times. The expansion will generate additional sales of 3,00,000, with a

return of 10% on sales before interest and taxes.

Required: If the company is to follow a policy of maximizing the market

value of its shares, which form of financing should it choose?

Income before interest and tax 62,000

Less: Interest 2,000

60,000

Income tax @ 40% 24,000

Income after tax 36,000

Page � of �49 55


38. The balance sheet of CANIH Ltd. as at March 31, current year is as

follows:

(Figures in lakhs of rupees)

Sales for the current year were ₹600 lakhs. For the next year ending on March

31, they are expected to increase by 20 per cent. The net profit margin after

taxes and dividend payout are expected to be 4 and 50 per cent respectively.

Required:

(a) Quantify the amount of external funds required.

(b) Determine the mode of raising the funds given the following parameters.

(i) Current Ratio should be 1.33.

(ii) Ratio of fixed assets to long-term loans should be 1.5.

(iii) Long-term debt to equity ratio should not exceed 1.06.

(iv) The funds are to be raised in the order of (1) short-term bank

borrowings, (2) long-term to and (3) equities.

Liabilities (₹) Assets (₹)

Share capital

Reserves

Long-term loans

Short-term loans

Payables

Provisions

200

140

360

200

120

80

Fixed asset

Investments

Receivables

Cash and bank

500

300

240

60

1,100 1,100

Page � of �50 55


39. The finance manager of KP Ltd has been trying to develop a financial

plan for the firm. He has, in coordination with other managers,

developed the following estimates (in lakh of rupees).

In addition, for planning purposes, he has made the following estimates and

assumptions about other results.

At the beginning of year 1, the treasurer expects the firm to have capital

employed of ₹270 lakhs and Debt-Equity Ratio of 1 : 2.

Particulars Year

1 2 3 4

Credit Sales

400

Increase by

20% Over

Previous

Year

Increase by

25% Over

Previous Year

Increase by

40% Over

Previous Year

Fixed Assets

to Turnover

Ratio

64% 56% 48% 40%

Operating Ratio 60%

Cash Sales 20% of Total Sales

Return on sales (after taxes) 10%

Dividend Payout Ratio 68%

Turnovers (times) based on year-end values:

Debtors Velocity 3 Months

Stock Velocity 4 Months

Required Current Ratio 2 : 1

Required Debt Equity Ratio 1 : 2

Page � of �51 55


Required: Determine how much additional equity capital, if any, the firm will

have to issue each year, if the finance manager's estimates and assumptions

are correct.

40. A Ltd. has appointed you as its Finance Manager. The company wants to

implement a project for which ₹60 lakhs is required to be raised from the

market as a means of financing the project. The following financing plans

at options are at hand:

(Number in thousands)

Assuming corporate tax to be 35 per cent and the face value of all the shares

and debentures to be ₹100 each, calculate the indifference points and Earnings

per share (EPS) for each of the financing plans. Which plan should be

accepted by the company?

41. The following data relate to two companies belonging to the same risk

class:

Required: (Use Net Income Approach)

Particulars Plan X Plan Y Plan Z

Option 1: Equity Shares 60 60 60

Option 2: Equity Shares 30 40 20

13% Preference Shares Nil 20 20

10% Nonconvertible Debentures 30 Nil 20

Particulars X Ltd. Y Ltd.

Expected Net Operating Income ₹50,000 ₹50,000

10% Debt ₹2,00,000 -

Equity Capitalization Rate 12.5% 10%

Page � of �52 55


(a) Determine the Total Value and the Weighted Average Cost of Capital for

each of company assuming no taxed.

(b) State the effect on the Total Value and Weighted Average Cost of Capital

in part (a) if X Ltd. has decided to raise the debt by ₹1,00,000 and use

the proceeds to buyback equity shares.

(c) State the effect on the Total Value and Weighted Average Cost of Capital

in part (a) if the X Ltd. has decided to issue the equity shares by

₹1,00,000 and use the proceeds to redeem the debt.

42. X Ltd.'s expected annual net operating income (EBIT) is ₹50,000. The

Company has 10% Debt ₹2,00,000. The overall capitalization rate is

12.5%.

Required: (Use NOI Approach)

(a) Determine the Total market Value of the company and Equity

capitalization rate.

(b) Determine the Weighted Average Cost of Capital to verify the validity of

the NOI approach.

(c) State the effect on the Total Value of the company and Weighted Average

Cost of Capital in part (a) if X Ltd. has decided to raise the debt by

₹1,00,000 and use the proceeds to buyback equity shares.

(d) State the effect on the Total Value of the company and Weighted Average

Cost of Capital in part (a) if the X Ltd. has decided to issue the equity

shares by ₹1,00,000 and use the proceeds to redeem the debt.

Page � of �53 55


43. In considering the most desirable capital structure for a company, the

following estimates of the cost of debt and equity capital (after tax) have

been made at various levels of Debt-Equity mix:

Required: Determine the optimal Debt-Equity mix for the company by

calculating composite cost of capital.

44. The following data relate to two companies belonging to the same risk

class:

Required:

(a) Determine the Total Value and the Weighted Average Cost of Capital for

each company assuming no taxes.

(b) Show the arbitrage process by which an investor who holds 10% equity

shares in X Ltd. will be benefited by investing in Y Ltd.

Debt as % of Total Capital

EmployedCost of Debt (%)

Cost of Equity

(%)

0 7.0 15.0

10 7.0 15.0

20 7.0 15.5

30 7.5 16.0

40 8.0 17.0

50 8.5 19.0

60 9.5 20.0

Particulars X Ltd. Y Ltd.

Expected Net Operating Income ₹6,60,000 ₹6,60,000

10% Debt ₹30,00,000 -

Equity Capitalization Rate 20% 15%

Page � of �54 55


(c) Will be gain by investing in the Undervalued Firm?

(d) Explain how he will be better off by investing the total funds available in

undervalued firm.

(e) When will this arbitrage process come to an end?

Page � of �55 55

Documents

Capital Structure - castudyweb.com...a) Capital Structure: 㾎The firm should strive to reach the optimal capital structure and its total valuation through a judicious use of the both