Capital Structure

(EBIT-EPS Analysis, Leverages, ROI-ROE, Financial Distress, Agency Cost, FRICTO)

1. If the use of financial leverage magnifies the earnings per share under favourable economic
conditions, why do companies not employ very large amount of debt in their capital structure?

2. What do you mean by FRICTO analysis? Discuss the importance

3. The following data is available for two firms:

Particulars Firm A (Rs.) Firm B (Rs.)

Quantity 20000 10000

Selling price 20 50
Variable cost per unit 15 30
Fixed cost 40000 70000
Interest 10000 20000
Preferred Dividend 5000 5000
Number of Equity shares 12000 15000
Tax rate 20% 30%

Calculate: EBIT, EPS, Degree of operating leverage, Degree of financial leverage, Degree of total
leverage, Break-even point in units and rupees.

4. A company’s current EBIT is 20 lacs. Its present borrowings are 14% term loans of Rs 40 lacs,
16% w. cap loan of Rs 33 lac and 15% public deposits of Rs 15 lac. The sales of the company are
growing and hence the company needs more working capital loan of Rs 25 lacs at same rate of
interest. Due to growing sales the EBIT shall increase by 20%. Calculate the change in Interest
Coverage Ratio after the additional borrowing.

5. A ltd has an average cost of debt 8%, and tax rate of 50%. The ROI is 14%. What is the financial
leverage ratio that the company should adopt, if the target ROE is 15%?

6. A company is planning to lower its selling price while keeping other costs constant. The current
details are given below:
Selling Price p/unit Rs 10

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 Number of units sold 3 lacs
Variable cost Rs 6
Fixed Cost 6 lacs
Prepare a statement indicating the volume necessary to maintain the net operating profit at current
level while lowering the selling price by 10% and 20%

7. A company earns a profit of Rs. 300,000 p.a. after meeting its interest liability of Rs. 120,000 on
12% debentures. The tax rate is 50%. The company has 80,000 equity shares of Rs. 10/- each, and
retained earnings amount to Rs. 12,00,000/-. The company proposes to take up an expansion
scheme for which a sum of Rs. 4,00,000 is required. It is anticipated that after expansion, the
company will be able to achieve the same return on investment as at present. The funds required
for expansion can be raised either through debt @ 12%, or by issuing equity shares at par.
Required:
a. Compute EPS if additional funds are raised through debt
b. Compute EPS if additional funds are raised through equity shares
c. Compare among alternatives, and advise the company as to which source of finance is preferred.

8. ABC Ltd is a zero-debt company, with an existing equity share capital of Rs 50 lacs comprising
of equity shares of face value Rs 10 each. The company has decided to invest in a project that
requires an outlay of Rs 75 lacs. These required funds can be raised, either by:
a) issuing fresh equity shares at par value, or
b) through debentures at 11% interest
The company has estimated that its EBIT in the worst-case economic scenario would be Rs 5 lacs,
and in best-case scenario EBIT would be Rs 25 lacs. The probability distribution of EBIT of ABC
Co, for various economic scenarios, is given below:

Economic Scenario Probability Projected EBIT (Rs lacs)

Best case 0.10 25
Growth case 0.15 22
Normal case 0.55 18
Slowdown case 0.15 10
Recession 0.05 05

Using EPS as the main criterion for decision: how would you raise the Rs 75 lacs required for
implementing the project? Through equity, or through debt? Show your reasoning and calculations
clearly.

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 9. The company needs additional working capital loan of Rs 25 lac and this loan will lead to a 20%
rise in EBIT. The company has undistributed reserves of Rs 6 lac. It needs another Rs 2 lac for
expansion. This amount will earn the same rate as funds already employed. You are told that D/E
ratio beyond 35% will push the P/E down to 8 and will raise cost of additional loan to 14%.
Ascertain the probable price of share a) if 2 lac are raise by loan b) if 2 lac are raise by issue of
equity

10. Calculate the level of EBIT at which the indifference point between the following financing
alternatives will occur (assume corporate tax rate of 30% and price of ordinary share at Rs. 10/-):
a) Ordinary share capital Rs. 10 lakh; or 15% debenture of Rs. 5 lakh and ordinary share capital
of Rs. 5 lakh
b) Ordinary share capital Rs. 6 lakh and 15% debenture of Rs. 4 lakh; or ordinary share capital
of Rs. 4 lakh, 13% preference capital of Rs. 2 lakh and 15% debentures of Rs. 4 lakh

11. The company’s current operating income is Rs 4 lac. The firm has Rs 10 lac debt at 10%. And
cost of equity capital is estimated at 15%. The firm is considering increasing the leverage by
raising additional debt of Rs 5 lac and use the proceeds to retire equal amount of equity. As a result
of the increased financial risk, the rate of interest is likely to go up to 12% and the cost of equity
will be 18%. Would you recommend the plan? Decide on basis of change in value of the firm.