Capital Structure

1) Companies X and Y are identical in all respects including

risk factor except for debt/equity, X having issued 10%
debentures of Rs. 18 Lakhs while Y has issued only equity.
Both the companies earn 20% before interest and taxes on
their total assets of Rs. 30 Lakhs. Assuming a tax rate of 35%
and capitalization rate of 15% for an all equity, compute
the value of companies X and Y using (i) net income approach
and (ii) net operating income approach

2) The following information is available regarding the Mid Air

Enterprises:
(i)
Mid Air currently has no debt, it is an all equity
company
(ii)
Expected EBIT = Rs. 24 Lakhs. EBIT is not expected to
increase overnight , so Mid Air is in no growth
situation
(iii) There are no taxes, so T = 0 per cent
(iv)
Mid Air pays out all of its income as dividends:
(v)
If Mid Air begins to use debt, it can borrow at the
rate kd = 8 %. This borrowing rate is constant and it
is independent of the amount of debt used. Any money
raised by selling debt would be used to retire common
stock, so Mid Air assets would remain constant;
(vi)
The risk of Mid Airs assets, and thus its EBIT, is
such that its shareholders require a rate of return Ke
= 12%, if no debt is used.
Using MM Model without corporate taxes and assuming a debt of
Rs 1 crore, you are required to:
(a) Determine the firms total market value
(b) Determine the firms value of equity
(c)
Determine the firms leveraged cost of equity.
3

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 Share

Market price per share
6% Debenture
Profit before interest

90,000
Rs. 1.20
60,000
Rs. 18,000

1,50,000
Re. 1.00
Rs. 18,000

All profits after debenture interest are distributed as dividends.

Required:
Explain how under Modigliani & Miller approach an investor holding 10% of
shares in Company X will be better off in switching his holding to Company Y.

4) For varying levels of debt- equity mix, the estimates of the

cost of debt and equity (after tax) are given below:
Debt as % of total
Cost of Debt
Cost of Equity
capital employed
0
7.0
15.0
10
7.0
15.0
20
7.0
16.0
30
8.0
17.0
40
9.0
18.0
50
10.0
21.0
60
11.0
24.0
You are required to decide on the optimal debt- equity for the
company by calculating the composite cost of capital.
5) Oneup Ltd. has equity share capital of Rs. 500,000 divided
into shares of Rs.100 each. It wishes to raise further Rs
3,00,000 for expansion-cum-modernization scheme. The company
plans the following financing alternatives:
i)
By issuing equity shares only
ii) Rs. 100,000 by issuing equity shares and Rs. 200,000
through debentures or term loan @ 10 % per annum.
iii) By raising term loan only at 10% per annum.
iv) Rs. 100,000 by issuing equity shares and Rs. 200,000 by
issuing 8% preference shares.
You are required to suggest the best alternative giving your
comment assuming that the estimated earning before interest and
taxes (EBIT) after expansion is Rs. 150,000 and corporate tax is
35%.

6 The existing capital structure of ABC Ltd is as follows:

(Rs)
Equity shares of Rs. 100 each
40,00,000
Retained Earnings
10,00,000
9% Preference Shares
25,00,000
7% Debentures
25,00,000
Company earns a return of 12% on its investments and the tax on
income is 50%.
Company wants to raise Rs. 25,00,000 for its expansion project
for which it is considering following alternatives:
i)
Issue of 20,000 Equity shares at a premium of Rs.25 per
share ii) Issue of 10% Preference Shares. iii) Issue of
9% Debentures
ii) Projected that the P/E ratios in the case of Equity,
Preference and Debenture financing Rs. 20, 17 and 16
respesectively.
Which alternative would you consider to be the best. Give reasons
for your choice.
7) The Modern Chemicals Ltd. requires Rs. 25,00,000 for a new
plant. This plant is expected to yield earnings before interest
and taxes of Rs. 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 Rs. 2,50,000 or Rs. 10,00,000 or Rs. 15,00,000
and the balance , in each case, by issuing equity shares. The
companys share is currently selling at Rs. 150, but is expected
to decline to Rs. 125 in case the funds are borrowed in excess of
Rs. 10,00,000. The funds can be borrowed at the rate of 10% upto
Rs. 2,50,000, at 15% over Rs. 2,50,000 and upto Rs. 10,00,000 and
at 20% over Rs. 10,00,000. The tax rate applicable to the company
is 50%. Which form is financing should the company choose?

8) A companys capital structure consists of the following:

(Rs in Lakhs)
Equity Shares of Rs.100 each
20
Retained Earnings
10
9% Preference Shares
12
7% Debentures
8
Total
50
Its Return on capital employed which is likely to remain
unchanged at 12 % after expansion. The expansion involves
additional finances of Rs. 25 Lakhs for which following
alternatives are available to it:
i)
Issue of 20,000 equity shares at a premium of Rs. 25 per
share
ii) Issue of 10% preference shares
iii) Issue of 8% Debentures
It is estimated that P/E ratio in the case of equity shares,
preference shares and debentures financing would be 21.4, 17 and
15.7 respectively. Which of these alternatives of financing would
you recommend and Why? The income tax rate is 50%.

9) A company needs Rs. 12,00,000 for the installation of a new

factory which would yield an annual EBIT of Rs. 200,000. The
company has the objective of maximizing the earnings per share.
It is considering the possibility of issuing equity shares plus
raising debt of Rs. 200,000, Rs. 600,000 or Rs. 10,00,000 . The
current market price per share is Rs. 40 which is expected to
drop to Rs. 25 per share if the market borrowings were to exceed
Rs. 750,000. Costs of borrowings are indicated as under:
Upto Rs. 250,000
Between Rs. 250,001 to Rs. 625,000
Between Rs. 625,001 to Rs. 10,00,000

10 % p.a
14 % p.a
16 % p.a

Assuming the tax rate to be 50%, work out the EPS and the scheme
which would meet the objectives of the management.

10 The ZBB Limited. Needs Rs. 5,00,000 for construction of a new

plant. The following three financial plans are feasible:

(i)
(ii)
(iii)

The company may issue 50,000 equity share at Rs. 10 per

share
The company may issue 25,000 equity share at Rs. 10 per
share and 2,500 debentures of Rs. 100 denomination
bearing 8% rate of interest
The company may issue 25,000 equity share at Rs. 10 per
share preference share at Rs. 100 per share bearing 8%
rate of dividend.

If the companys earnings before interest and taxes are Rs.

10,000, Rs. 20,000, Rs. 40,000, Rs. 60,000 and Rs. 100,000,
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%.
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 shares of the value
of Rs. 200 Lakhs and by loan of Rs. 100 Lakhs at 15% interest.
Assuming a tax rate of 50%, calculate the figures of profit,
before tax that would keep the equity investors indifferent to
the two options. Verify your answer by calculating the EPS.

12) M C Ltd is planning an expansion programme which will require

Rs. 30 crores and can be funded through one of the three
following options:
(a) Issue further equity shares of Rs. 100 each at par,
(b) Raise loans at 15% interest,
(c) 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 at 50%.
After the expansion, EBIT is expected to be Rs. 15 crores p.a
Calculate EPS under the three financing options indicating the
alternative giving the highest return to the equity shareholders.
Determine the point of indifference between Equity Share Capital
and Debt [i.e option (a) and (b) above]
13) PCB Corporation has plans for expansion which calls for 50%
increase in assets. The alternatives before the Corporation are
issued of equity shares or debt at 14%.Its balance sheet and
profit and loss accounts are given below:

Balance Sheet as at 31st March 2002

Liabilities
Rs in Lakhs
Assets
12% Debentures
Ordinary Shares
- 10 Lakhs share of Rs
10 each
General Reserve
Total

25
100

Total Assets

Rs. In
Lakhs
200

75
200

200

Profit and Loss Account for the year ending 31st March 2002
Rs in Lakhs
Sales
750
Total Cost Excluding Interest
675
EBIT
75
Interest on Debentures
3
EBT
72
Taxes
36
EAT
36
Earning per share (EPS) =
=
P/E Ratio
=
Market Price
=

Rs. 36,00,000/10,00,000
Rs. 3.60
5 times
Rs. 18.00

If the Corporation finances the expansion with debt, the

incremental financing charges will be at 14% and P/E Ratio is
expected to be at 4 times. If the expansion is through equity,
the P/E Ratio will remain at 5 times. The company expects that
its new issues will be subscribed to at a premium of 25%
(i)
If EBIT is 10% of sales, calculate EPS at sales at
levels of Rs. 4 crores, Rs. 8 crores and Rs. 10 crores.
(ii)
After expansion determine at what level of EBIT, EPS
would remain the same, whether new funds are raised by
equity or debt
(iii) Using P/E Ratios calculate the market value per share
at each sales level for both debt and equity financing.

14) Super Limited is considering three financial plans:

Financial
Equity
Debt
Preference
Plans
A
100%
B
50%
50%
C
50%
50%

Total Funds to be raised

Rate of Interest on Debt
Corporate tax rate
Dividend on Preference Shares
Face Value of Equity Shares

-Rs 200 crores

-12%
-35%
-9%
-Rs. 10 each. The share will
Issued at a premium of 10
per share
- Rs. 80 crores

Expected EBIT
Determine:
(i)
EPS and Financial break even point for each plan
(ii)
Indifference points between financial plan A AND B, A
and C.
15) The Sales and Earnings before interest and Taxes (EBIT) for a
company during the year 2002 were Rs. 17,50,000
and
Rs.
4,50,000 respectively. During that year the expenses on account
of interest was Rs. 4,000 and on Preference Dividend was
Rs.10,000 These fixed charges are expected to continue during
2003. For the year company is planning an expansion which will
cost Rs. 1,75,000 and expected to increase EBIT to Rs. 5,50,000
The company is considering the following alternatives to finance
the expansion:
(a)
(b)
(c)

Issue of 5,000 Equity shares at Rs. 35 each. The company

presently has 40,000 Equity shares
Issue Rs. 1,75,000 of 15- year Bond @ 8%
Issue of Additional preference shares @ 8.5% for Rs.
1,75,000.

You are required to calculate:

(i)

EPS for 2001 at the expected EBIT OF Rs. 5,50,000 for

the three financing options
(ii)
The equivalency level of EBIT between Debt and Equity
(iii) The equivalency level of EBIT between Preference and
Equity.
Assume Income Tax @ 50%.