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Financial Management II
Guided By: Prof. Dr. V. Narender
Objective: To find the optimal capital structure for a soft
drinks company.
Group Number: 03.
Group members:
1.Sumant (Seat No. 11)2.Amrita (Seat No. 12)3.Kishan Rathi (Seat
No. 13)4.Shivi Gupta (Seat No. 14)5.Abhishek Kr. Sinha (Seat No.
15)
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Given:-
Sales: (0.25*400000+0.5*600000+0.25*800000) = 6, 00,000.00
Fixed Cost: 2, 00,000.00
Variable cost: 50% of sales = 3, 00, 000.00Total Cost: 5, 00,
000.00
NOI = (6, 00,000.00 - 5, 00, 000.00) = 1, 00, 000.00
Initial Capital structure = 0% debt and 100% equity.As we know
that,
WACC (Ko) =NOI/V
Value of the firm = D+E =5, 00, 000.00
Ko= 1, 00, 000/5, 00, 000 =0.2 =20%
As NOI & V will always be constant thats why Ko will also be
constant even in the case when there is
change in capital structure.
Now, We know that Ko=(D/V)Kd + (E/V)Ke.Solving for Ke,Ke =
WACC(Ko)+(WACC(Ko)-Cost of Debt(Kd))*(Debt(D)/Equity(E)).
Ke= 0.2 + 0 = 0.2
THE FIRM IS CONSIDERING SEVEN ALTER-NATIVE CAPITAL STRUCTURES
WITH A DEBT
OF 0, 10, 20, 30, 40, 50 AND 60 PER CENTS AND THE RATE OF
INTEREST WILL BE 9.0%, 9.5%,
10.0%, 11.0%, 13.5%, AND 16.5% RESPECTIVELY.
ASSUMPTIONS:-
1. THE FIRM HAS NO CURRENT LIABILITIES2. ITS CAPITAL STRUCTURE
CURRENTLY CONTAINS ALL EQUITY AS IN THE B/S.3. THE TOTAL AMOUNT OF
CAPITAL REMAINS CONSTANT.
These are the basic assumptions which we have followed for the
entire case.
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FORMULA USED:-
Equation Formula
1 Firm's cost of capital(ko) =(Net operating income(NOI)/ Value
of the firm(V))
2 Cost of equity(Ke)=WACC(Ko)+(WACC(Ko)-Cost of
Debt(Kd))*(Debt(D)/Equity(E))
3 Interest(I)=kd*D
4 Earning before Tax(EBT)=Net operating
income(NOI)-Interest(I)
5 Ko=NOI/V
6 V=E+D
7 EPS=(EBT/No. of Shares)
8 No. of Shares=(Equity/20)
Solving for the case for different conditions given below-
Condition NOI Equity Debt V=E+D Ko Kd Ke I EBT N EPS
D = 00%, Kd = 00% 100000 500000 0 500000 0.2 0 0.2 0 100000
25000 4
D = 10%, Kd = 9.0% 100000 450000 50000 500000 0.2 0.09 0.21 4500
95500 22500 4.2444
D = 20%, Kd = 9.5% 100000 400000 100000 500000 0.2 0.1 0.23 9500
90500 20000 4.525
D = 30%, Kd = 10% 100000 350000 150000 500000 0.2 0.1 0.24 15000
85000 17500 4.8571
D = 40%, Kd = 11% 100000 300000 200000 500000 0.2 0.11 0.26
22000 78000 15000 5.2
D = 50%, Kd = 13.5% 100000 250000 250000 500000 0.2 0.14 0.27
33750 66250 12500 5.3
D = 60%, Kd = 16.5% 100000 200000 300000 500000 0.2 0.17 0.25
49500 50500 10000 5.05
We found EPS to be maximum at D=50% with Kd = 16.5%
The MM1 Model suggests that there is no as such concept of
optimum capital structure because the value
of the company is independent of the mix ratio of debt and
equity. In other words, the value of the firm is
independent of the debt-equity mix. Here, we are observing that
the net value of the firm is D+E which
comes out to be 5,00,000.00 in all the cases.
In the attached Excel sheet, we have observed the different
values of Ke for different situations of mix of
debt and equity ratio. The ultimate mission of any firm is to
maximize the wealth of the shareholder. So
as a finance officer, I will prefer that mix ratio which
maximizes the returns for the share holder.
So, when we calculated the different values for the different
propositions debt and equity, we can see
from the sheet one of the attached file that for 50% debt and
50% equity, the maximum returns for the
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share holders can be found. In the first sheet, we are assuming
that the face value and the market value of
the shares are constant.
In the second sheet of the excel sheet which is attached, we can
see that we have assumed that the market
value and the face value for each share is different which
generally happens in practical life. We have
assumed that the book value is Rs. 10 whereas the market value
is Rs. 20. Under that condition, we again
compute the values for Ke. In this case also we found that again
for the same financial leverage of 0.5, the
EPS for the shareholders get maximized.
So, as a finance manager, I will advice the company for the
financial leverage of 0.5 which optimizes the
returns for the share holders. As a finance manager, I will look
for the value maximization of the share
holders from each share. Kindly see the excel sheet attached
herewith to find the detailed solution.
