Capital Structure Decisions

4/11/2020
Assignment - 1

Submitted To : Prof. Vinay H V

(Department of Business Administration)

Submitted by : Yousuff Pasha

2ND YEAR “A” SECTION
4TV19MBA43
MBA
VVCE
 Exercise Problems

1. M/s Exelon Company Ltd is expecting an annual EBIT of Rs.1 lakh. The Company
has Rs.4 lakhs in 10% debentures. The cost of equity capital or equity
capitalization rate is 12.5%. You are required to calculate the total value of the
firm. Also state the overall cost of capital.

2. M/s Exelon (Debt-up) Company Ltd is expecting an annual EBIT of Rs.1 lakh. The
Company has Rs.4 lakhs in 10% debentures. The equity capitalization rate is
12.5%. The company is deciding to raise Rs.1 lakhs by issue of 10% debentures
& use the proceeds to redeem equity shares. You are required to calculate the
total market value of the firm and also the overall cost of capital.

3. M/s Waylon Company Ltd has an EBIT of Rs.1 lakh. The cost of debt is 10% and
the outstanding debt amount is Rs.4 lakhs. The overall capitalization rate of
12.5%.The Company decides to raise a sum of Rs.1 lakh through debt at 10%
and use the proceeds to pay out the equity shareholder of like value. Calculate
the total value of the firm & equity capitalization rate.

4. (a) M/s Max Limited has a capital of 25 lakhs consisting of Rs.10,00,000 of 12%
debt. The Equity Capitalization Rate is 20%. If the EBIT of M/s Max Limited as at
31.03.2010 is Rs.2,00,000, determine;
(a) the Market Value of equity,
(b) the Market Value of debt,
(c) the Market Value of the Firm
(d) Weighted Average cost of Capital (WACC) as per Net Income Approach.

(b). The company also desires to alter the debt composition to 50% or 60% of
the total capital. What would be the Market Value of Equity, Market Value of
debt and Total Market Value in such an event & also determine the Weighted
Average cost of capital.
5. A firm has annual net operating income of Rs.100,000, an average cost of capital
of 10% and an initial debt of Rs.5,00,000 at 6% rate of interest. Determine the
Total Value of the firm, Market Value of Equity, Market Value of Debt under NOI
approach.

6. The value for two firms X which is an un-levered firm and Y which is a levered
firm with Rs.6,00,000 debt at 6% rate of interest are given as follows;
Particulars. X Y
Net Operating income 2,00,000 2,00,000
Cost of debt - 36,000
Net earnings to SHs 2,00,000 1,64,000
Equity-capitalization 0.111 0.125
rate
Market Value of Equity 18,00,000 13,12,000
Market Value of Debt - 6,00,000
Total Value of firm 18,00,000 19,12,000
Overall capitalization 0.1110 0.1046
rate
An investor holds Rs.20,000 worth of Y Company shares. Show the process by
which he can earn same return at a lesser cost.

7. Two firms A & B are identical in all respect except that B has Rs.5,00,000 debts
outstanding at a 6% of interest. The values of the two firms are as follows;

Particulars. A B
Net Operating income 1,50,000 1,50,000
Cost of debt - 30,000
Net income to SHs 1,50,000 1,20,000
 Equity capitalization 0.10 0.15
rate
Market Value of shares 15,00,000 8,00,000
Market Value of Debt - 5,00,000
Total Market Value 0.10 0.1154
Assume that an investor owns 10 percent of A shares. How can the investor
obtain same return at a lower cost?

8. The following is the data regarding two companies U Ltd & L Ltd belong to the
same risk class.
Particulars. L Ltd. U Ltd.
EBIT 80,000 80,000
Less: Interest 50,000 NIL
Earnings to SHs 30,000 80,000
Cost of Capital Ke 0.16 0.125
Market Value of Equity 1,87,500 6,40,000
Market Value of debt 5,00,000 NIL
Total Market Value 6,87,500 6,40,000
Discuss how arbitrage would start as per MM Theory for a person holding; say
10% in firm L Ltd.

9. M/s Anil Automobiles operates in the auto spares industry. The income
statement of the company is follows;
 Particulars Sales Cost of NOI Interest Earnings to
Sales Shareholders
Amount (Rs. in 500.00 300.00 200.00 60.00 140.00
lakhs)

The capitalization rate of debt is 10% and capitalization rate for entire firm is
12.5%. Assume that the Net Operating Income approach to capital structure is
applicable.

(a) What is the Market Value of Debt of the firms?

(b) What is the total Market value of the firms?
(c) What is the Market Value of the Equity of the firm?
(d) What is the Equity Capitalization Rate?
(e) Does Anil Automobiles have optimum capital structure?

10. M/s Delta Ltd Company currently has an equity share capital of Rs.10,00,000
consisting of Rs.1,00,000 equity share of Rs.10 each. The Company is going
through a major expansion plan requiring raising funds to the tune of
Rs.6,00,000. to finance the expansion the Management has the following plans;

Plan I Issue 60,000 equity shares of Rs.10 each,

Plan II Issue 40,000 equity shares of Rs.10 each and the balance
through long
term borrowings at 12% interest per annum,
Plan III Issue 30,000 equity shares of Rs.10 each and 3000
Rs.100, 9% Debentures
Plan IV Issue 30,000 equity shares of Rs.10 each and the balance
through
6% Preference Shares.
 The EBIT of the Company is expected to be Rs.4,00,000 per annum. Assume
corporate tax of 40%. You are required to calculate EPS in each of the above
case. Also compute the degree of Financial Leverage

11. M/s New High Lands Company Limited has a capital structure of Rs.25 lakhs
divided into 2,50,000 equity shares of Rs.10 each. Their Earnings before interest
& taxes for the financial year 2010-11 stood at Rs.7,50,000. The company is in
the 50% tax brackets. For the year 201112 the company is contemplating
expansion requiring additional investment of Rs.20 lakhs & EBIT is expected to
go up by Rs.1,75,000. M/s Alex & Stewarts, their chartered accountants have
suggested four alternatives to augment the capital as below;

Option A: Issue further 2,00,000 equity shares at Rs.10 each,

Option B: Issue further 1,50,000 equity shares and rise balance in form of debt
that carry 12 per cent interest rate per annum,

Option C: Issue further 1,00,000 equity shares, Rs.5,00,000 by 12% debt,

balance by

Preference shares of face value Rs.25 carrying 9% dividends,

Option D: Issue further 50,000 equity shares, Rs.10,00,000 by 12% debt,

balance by Preference shares of face value Es.25 carrying 9%
dividends.

From the information given above, you are required to

Calculate the EPS under the various options including current EPS of M/s New
High Lands Company Limited.

12. M/s VS International Ltd., has a capital structure (all equity) comprising of
Rs.5,00,000 each of share of Rs.10. The firm wants to raise an additional
Rs.2,50,000 for expansion project. The firm has the following four alternative
financial plans I, II, III and IV. The firm is able to earn an operating profit at
 Rs.80,000 after additional investments and 50 per cent tax rate. Calculate EPS
for all four alternatives and select the preferable financial plan. Financial plan;

(i) Raise the entire amount in the form of equity capital,

(ii) Raise 50 per cent as equity capital and 50 per cent as 10 per cent debt
capital,
(iii) Raise the entire amount as 12 per cent debentures,
(iv) Raise 50 per cent equity capital and 50 per cent preference share
capital at 10 per cent.

13. M/s KPMG Ltd has currently an ordinary share capital of Rs.25 lakhs, consisting
of 25,000 shares of Rs.100 each. The management is planning to raise another
Rs.20 lakhs to finance a major program of expansion through one of the four
possible financial plans as below;
(i) Entirely through ordinary shares,
(ii) Rs.10 lakhs through ordinary shares and Rs.10 lakhs through long-term
borrowings at 8 per cent interest per annum,
(iii) Rs.5 lakhs through ordinary shares and Rs.15 lakhs through long term-
term debt borrowing at 9 per cent per annum,
(iv) Rs.10 lakhs through ordinary shares and Rs.10 lakhs through
preference shares with 5 per cent dividend.
The company’s expected EBIT will be Rs.8 lakhs. Assuming a corporate tax rate
of 46 per cent, determine the EPS in each alternative and comment which
alternative is best and why?

14. M/s AB Ltd needs Rs.10,00,000 for the installation of a new factory. The new
factory is expected to yield an annual EBIT of Rs.1,60,000. In choosing a financial
plan, M/s AB Ltd has an objective of maximizing earnings per share. It is
considering the possibility of issuing common shares and rising debt of
Rs.1,00,000, or Rs.4,00,000 or Rs.6,00,000. The current market price per share
is Rs.25 and is expected to drop to Rs.20 if the funds are borrowed in excess of
Rs.5,00,000. Funds can be borrowed at the rates indicated below:
 Up to Rs.1,00,000 at 8%,

Over Rs.1,00,000 to Rs.5,00,000 at 12%,

Over Rs.5,00,000 at 18%

Assume a tax rate of 50 per cent. Determine the EPS for the three financing
alternatives.

15. For varying level s of debt-equity mix, the estimates of the cost of debt and
equity capital after tax are given below:

Debt as % of total Cost of Cost of

Capital Debt Equity
0 5.0 12.0
10 5.0 12.0
20 5.0 12.5
30 5.5 13.0
40 6.0 14.0
50 6.5 16.0
60 7.0 20.0

You are required to decide on the optimal debt-equity mix for the Company by
calculating the composite cost of capital.

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