CAPITAL STRUCTURE Problems

CAPITAL STRUCTURE DE7oCISIONS & PLANNING
1. The values of 2 firms X and Y in accordance with the traditional theory are given below:
Particulars X Y
Expected operating income (X) 50000 50000
Rs
Total cost of debt (D=R) 0 10000
Net income 50000 40000
Cost of equity 0.10 0.1111
Market value of shares (S) 500000 360000
Market value of debt (D) 0 200000
Total value of firm (V=S+D) 500000 560000
Average cost of capital (Ko) 0.10 0.09
Debt equity ratio 0 0.556
Compute the values of firms X and Y as per the MM hypothesis. Assume that i) corporate
income taxes do not exist ii) the equilibrium values of Ko is 12.5%.
2. A company’s current operating income is Rs 4 lakhs. The firm has Rs 10 lakhs of 10%
debt outstanding. Its cost of equity is estimated to be 15%
a) Determine the current value of the firm using traditional valuation approach
b) Calculate the overall capitalisation rate as well as both types of leverage ratio: B/S and
B/V
c) The firm is considering increasing its leverage by raising an additional Rs 500000 debt
and using the proceeds to retire that amount of equity. As a result of increased financial
risk Ki is likely to go up to 12% and Ke to 18%. Would you recommend the plan?
3. The companies U and L belong to an equivalent risk class. These 2 firms are identical in
every respect except that U company is unlevered while company L has 10% debentures of
Rs 30 lakh. The other relevant information regarding their valuation and capitalisation rates
are as follows:
Particulars Firm U Firm L

Net operating income EBIT (Rs) 750000 750000
Interest on debt (I) - 300000
Earning to equity holders (NI) 750000 450000
Equity capitalisation rate (Ke) 0.15 0.20
Market value of equity (S) 5000000 2250000
Market value of debt (B) - 3000000
Total value of firm (S+B)=V 5000000 5250000
Implied overall capitalisation rate 0.15 0.143
(Ko)
Debt equity ratio (B/S) 0 1.33
a) An investor owns 10% equity shares of company L. show the arbitrage process and the
amount by which he could reduce his outlay through the use of leverage
b) According to MM, when will this arbitrage process come to end?
4. The following is the data regarding two companies X and Y belonging to the same equivalent
risk class-
Particulars Company X Company Y

Number of ordinary shares 90000 150000
Market price per share RS 1.20 Rs 1
6% Debenture 60000 -
Profit before interest Rs 18000 Rs 18000
All profits after debenture interest are distributed as dividend. Required- Explain how under MM
approach , an investor holding 10% of shares in company X will be better off in switching his
holding to company Y.
CAPITAL STRUCTURE DECISIONS & PLANNING
5. Radiant Technology has a project costing Rs 15 crore for making high-end microchips on
hand. It shall provide the earning level of Rs 4 crore annually. With a view to decide the desired
capital structure the firm compiled following data with respect to cost of debt and cost of equity
for debt levels of 20% to 70% of the cost of the project, that is reproduced below:
Examine which of the capital structure is best for Radiant Technology.
6. Mangal Dass Enterprises is in the business of manufacture and export of garments. Currently
in its capital structure it has a debt of Rs 15 crores with cost of 10%. The cost of equity is
reckoned at 15%. It has earnings level of Rs 3.75 crores and does not pay any taxes being tax-
exempt unit. The Managing Director of the firm believes that the level of debt is too high and
would like to repay the debt by issuing additional shares to the extent of Rs 5 crore. According to
him reduced level of leverage would reduce the cost of capital because of two reasons - cost of
debt falling from existing 10% to 9%, and cost of equity falling from 15% to 14%. Evaluate the
option of the Managing Director to replace debt with equity. Also find the WACC and value of
the firm in both the situations.
7. MN Ltd is planning an expansion program which will require Rs 30 crores and can be funded
through one of the three following options:
(a) Issue further equity share of Rs100 each at par.

(b) Raise loan at 15% interest
(c) Issue preference share at 12%
Present paid up capital is Rs 60 crores and average annual EBIT is Rs 12 crores. Assumed
income tax rate is 50%. After the expansion, EBIT is expected to be Rs 15 crores per annum.
Calculate EPS under the three financing plan.
8. The Zee Ltd needs Rs 5,00,000 for construction of new plant. The following three financial
plans are feasible:
(i) The company may issue 50,000 equity shares at Rs 10 per share.
(ii) The company may issue 25000 equity shares at Rs 10 per share and 2500 debentures
of Rs 100 denomination bearing an 8% rate of interest.
(iii) The company may issue 25000 equity shares at Rs 10 per share and 2500 preference
shares at Rs 100 per share bearing 8 % rate of dividend.
If the company’s earnings before interest and taxes are Rs 40,000, Rs 60,000 and Rs 1, 00,000,
what are the earnings per share under each of the three financial plans? Which alternative would
you recommend and why? Assume corporate tax rate to be 50%.
9. The following data of Krish Ltd is as follows-
Earnings before interest and taxes 23,00,000

Less: Debenture interest 8% 80,000
Long term interest @ 11% 2,20,000 3,00,000
Earnings before tax 20,00,000
Less: Income tax 10,00,000
Earnings after tax 10,00,000
Number of euity shares of Rs 10 each 5,00,000
EPS Rs 2
Market price of share Rs 20
P/E ratio 10
The company has undistributed reserves and surplus of Rs 20 lakh. It is in need of Rs 30 lakh to
pay off debentures and modernize its plants. It seeks your advice on the following alternative
modes of raising finance:
Alternative1- Raising entire amount as term loan from bank @12%
Alternative 2- Raising part of the funds by issue of 1, 00,000 shares of Rs 20 each and the rest
by term loan at 12%.
The company expects to improve its rate of return by 2% as a result of modernization, but P/E
ratio is likely to go down to 8 if the entire amount is raised as term loan.
(i) Advice the company on the financial plan to be selected.

(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?
10. AB Ltd provides you the following information:
Earnings before interest and taxes 3,00,000

Less: Interest on debenture @ 12% 60,000
2,40,000
Income tax @ 50% 1,20,000
Profit after tax 1,20,000
Number of equity shares(Rs10 each) 40,000
EPS (Earning per share) Rs 3
Price in market Rs 30
P/E Ratio (MP/EPS) 10
The company has undistributed reserves of Rs 6, 00,000. The company needs Rs 2, 00,000 for
expansion. This amount will earn at the same rate as funds already employed. You are informed
that a debt equity ratio higher than 35% will push the P/E ratio down to 8 and raise the interest
rate on additional amount borrowed to 14%. You are required to ascertain the probable price of
share:
(a) If the additional funds are raised as debt,
(b) If the amount is raised by issuing equity shares
EBIT- EPS Indifference Point
11. A new project under consideration requires a capital outlay of Rs 300 lakhs. The required
funds can be raised either fully by equity shares of Rs 100 each or by equity share of value of Rs
200 lakhs and by loan of Rs 100 lakh at 15% interest. Assuming a tax rate of 50%, calculate the
figures of profit before interest and tax that would keep the equity investors indifferent to the two
options. Verify your answer by calculating EPS.

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CAPITAL STRUCTURE DE7oCISIONS & PLANNING

Particulars Firm U Firm L

Particulars Company X Company Y

CAPITAL STRUCTURE DECISIONS & PLANNING

Examine which of the capital structure is best for Radiant Technology.

(a) Issue further equity share of Rs100 each at par.

9. The following data of Krish Ltd is as follows-

Earnings before interest and taxes 23,00,000

Alternative1- Raising entire amount as term loan from bank @12%

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

10. AB Ltd provides you the following information:

Earnings before interest and taxes 3,00,000

EBIT- EPS Indifference Point

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