CAPITAL STRUCTURE

Capital Structure: Capital structure refers to the mix of sources from where the long-term funds required in a business may be raised. So it refers to the proportion of Debt, Preference Capital and Equity Capital Optimum Capital Structure: One of the basic objectives of financial management is to maximize the value or wealth of the firm. Capital structure is optimum when the firm has a combination of equity and debt so that the wealth of the firm is maximum. At this level cost of capital is minimum and market price per share is maximum. Features of an appropriate Capital Structure 1. Profitability: It should minimise the cost of financing and maximize EPS 2. Flexibility: The capital structure should be such that the company can raise funds when required 3. Solvency: The capital structure should be such that the company does not run the risk of being insolvent 4. Control :There should be minimum risk of loss or dilution of control of the Company Major Consideration in Capital Structure planning Type Risk Cost Low Risk Most Expensive Equity Capital Slightly higher Slightly cheaper cost Preference Capital risk High risk Comparatively cheaper Loan Funds

Control Dilution of Control No dilution of control No dilution of control

1. One Ltd has equity share capital of ` 5, 00,000 divided into shares of ` 100 each. It wishes to raise further ` 3, 00,000 for expansion cum modernization scheme. The company plans the following financing alternatives: i. By issuing equity shares only. ii. ` 1, 00,000 by issuing equity shares and ` 2, 00,000 through debentures or term loan @ 10% p.a. iii. By raising term loan at 10% p.a. iv. ` 1, 00,000 through equity shares and ` 2, 00,000 by issuing 8 % Preference Shares. You are required to suggest the best alternative giving your comment assuming that the estimated earnings before interest and tax after expansion is ` 1,50,000 and corporate tax is 35%. 2. Fitwell Company is now capitalised with Rs 50,00,000 consisting of10,000 ordianry shares of Rs. 500 each. Additional finance of Rs.50,00,000 is required for a major expansion programme launched by the company. Four possible financing plans are under consideration. These are : i. Entirely through additional shares, issuing 10,000 shares of Rs.500 each. ii. Rs. 25 Lakhs through ordinary share capital and Rs.25 Lakhs through borrowing from term lending institutions at 12% interest. iii. Entirely through borrowings from the term lending institutions at 13% interest. iv. Rs.25 Lakhs through 10% ordinary share capital and Rs. 25 Lakhs through 10% preference shares, by issuing 5,000 preference shares of Rs. 500 each.

The Companys existing earnings before interest and tax amounted to Rs. 6 Lakhs. By virtue of the increase in capitalisation, the earnings before interest and tax are expected to double the present level. Examine the impact of financial leverage of these four plans and calculate the earnings per share for the shareholders in each case. Assume 50% tax rate 3. The modern Chemicals Ltd requires ` 25, 00,000 for a new plant. This plant is expected to yield earnings before interest and tax 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 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% upto ` 2, 50,000 at 15% over ` 2, 50,000 and upto ` 10, 00,000 and at 20% over ` 10, 00,000. The tax rate applicable to the company is 50%. Which form of financing should the company choose? 4. A new project under consideration requires a capital outlay of ` 300 Lakhs. The required funds can be raised either fully by equity shares of ` 100 each or by equity shares of the value of ` 200 Lakhs and by loan of ` 100 Lakhs are 15% interest. Assuming a tax rate of 50% calculate the figure of profit before tax that would keep the equity investors indifferent to the two options. Verify your answer by calculating the EPS. 5. M Ltd is planning an expansion which will require Rs. 30 crores and can be funded through one of the three following options: i. ii. iii. Issue further equity shares of Rs. 100 each at par, Raise loans at 15% interest Issue preference shares at 12% Present paid up capital is Rs. 60 crores and average annual EBIT is Rs. 12 crores. Assume Income Tax Rate of 50%. After the expansion, PBIT is expected to be Rs. 15 crores p.a. Calculate EPS unde the three financing options indicating the alternatives giving the highest return to the equity shareholders. Determine the point of indifference between Equity Share Capital and Debt (i.e. option (i) and (ii) above)

6. A companys capital structure consists of the following ` in Particulars Lakhs Equity Shares of ` 100 each 20 Retained Earnings 10 9% Preference Shares 12 7% Debentures 8 Total 50 The Company earns 12% on its Capital. The Income Tax Rate is 50%. The Company requires a sum of ` 25 Lakhs to finance its expansion for which following alternatives are available to it. i. Option A: Issue if 20,000 Equity Shares at a premium of ` 25 per share

ii. Option B: Issue of 10% Preference Shares iii. Option C: Issue of 8% Debentures It is estimated that the Price Earnings Ratio in the case of Equity, Preference and Debentures financing would be 21.4, 17 and 15.7 respectively. Which of the three financing alternatives would you recommend and why? 7. Inland Co. Ltd is considering an expansion programme which is expected to cost ` 10, 00,000. The company can finance it either through Debt or through Equity. Its current financing pattern is given as belowSource ` Equity Capital 500,000 Reserves & Surplus 200,000 Debt (10%) 300,000 Total 1,000,000 The latest income statement reveals the following information Particulars ` Sales 6,400,000 Less: Cost of Sales (5,900,000) EBIT 500,000 Less: Interest (30,000) EBT 470,000 Less: Tax @ 50 % (235,000) EAT 235,000

The expansion programme is expected to generate additional sales of ` 16, 00,000 with a return of 15% on sale, before Interest and Taxes. i.If the expansion is financed through debt, the rate of new debt will be 12% and the Price- Earnings Ratio will be 4 times. ii. If the expansion is financed through Equity Share i.e. the new shares can be sold at a price of ` 40 and the price to earnings ratio will be 5 times. Which form of financing should the company choose if the objective of financial management if the company is maximization of shareholders wealth?

8. The following figures of Krish Ltd are presented to you Particulars ` Earnings before Interest and Tax 2300000 Less: Debenture Interest @ 8% -80000 Less: Long term Interest @ 11% -220000 Earnings before Tax 2000000 Less: Income Tax -1000000

Earnings after Tax No of Equity Shares of ` 10 each Earnings per share Market price per share Price Earnings Ratio

1000000 500000 2 20 10

The Company has undistributed reserves and surplus of ` 20 Lakhs. It is in need of ` 30 Lakhs to pay off Debentures and modernize its plants. It seeks your advice on the following alternatives modes of financeAlternative A: Raising entire amount as term loan from banks @ 12% Alternative B: Raising part of the funds by issue of 1, 00,000 shares of ` 20 each and the rest by term loan @ 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. Requiredi.Advise 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 are adopted, would you advice still hold good