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5. CAPITAL STRUCTURE
SOLUTIONS TO ASSIGNMENT PROBLEMS
Problem No.1
Evaluation of different capital structures given in the problem:
% of debt % of equity Cost of debt(Ki) Cost of equity(Ke) WACC (KO)
0% 100% 6% 11.5% 11.5%
10% 90% 6% 12% 6*10%+12*90%=11.4%
20% 80% 6% 12% 6*20%+12*80%=10.8%
30% 70% 6.5% 13% 6.5*30%+13*70%=11.05%
40% 60% 7% 15% 7*40%+15*60%=11.8%
50% 50% 7.5% 17% 12.25%
60% 40% 8% 20% 12.8%

Decision: since the WACC is minimum 20% of debt and 80% equity represents optimum capital
structure.

Problem No.2
Calculation of EPS under all the three options (Rs. In Lakhs)

Particulars Option I Option II Option III

Equity 22.5 15 10
Debt 2.5 10 15
EBIT 5 5 5
Less: Interest (2.5 X 10%) 0.25 (2.5X10%+75X15%) 1.375 (1.375+5X20%) 2.375
EBT 4.75 3.625 2.625
Less: Tax @ 50% 2.375 1.8125 1.3125
EAT /EAESH (A) 2.375 1.8125 1.3125
No. of shares (B)  22.5   15   10 
0.15   0.1   0.08  
 150   150   125 

EPS (A/B) 15.83 18.125 16.41

Conclusion: The objective of the financial management is to maximize the benefits of equity share
holders. Since EPS is maximum in option II, it is beneficial to raise the required funds of 25,00,000 as
15,00,000 through equity and 10,00,000 through debt.

Problem No.3
Statement showing the selection of best finance option

Particulars Debt Equity

EBIT - Existing 31,000 31,000
- New 15,000 15,000
Total EBIT 46,000 46,000
Less: Interest - Existing 1,000 (20KX7%) 1,000
- New 3,500 (50000X7%)
EBT 41,500 < 45,000
Less: Tax @ 35% (Note) 14,525 15,750

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EAT /EAESH (A) 26,975 29,250
No. of shares – Existing 5,000 5,000
 50,000 
- New - 2,000  
 25 

(B) 5,000 7,000

EPS (A / B) 5.395 4.18
PE ratio 6 7
MP (EPS X PE ratio) 32.37 29.25
10,500
Note: Income Tax rate = × 100 =35%
30,000
Conclusion: Since Market Price higher, in case of debt, it is the best capital structure.

Problem No.4
Calculation of interest coverage ratio (Rs. in Lakhs)

Before Additional After Additional

Particulars
borrowings borrowings
EBIT (A) 22 26.4 (22X120%)
Interest on term loan (40 X 11%) 4.4 4.4
Interest on bank borrowings (30X16%) 4.8 4.8
Interest on public deposit (15X12%) 1.8 1.8
Interest on additional Bank borrowing --- 4 (25X16%)
Total interest (B) 11 15
Interest Coverage Ratio (A/B) 2 times 1.76 times
Conclusion: The interest coverage ratio has decrease from 2 times to 1.76 times. This is not a
favourable situation for money lender / creditor.

Problem No.5
Evaluation of the given four financial plans on the basis of EPS (Rs. in lakhs)
Particulars Option A Option B Option C Option D
Existing equity share capital 40 40 40 40
Fresh issue of equity 40 20 10 20
Debt - 20 30 -
Preference shares - - - 20

Particulars Option A Option B Option C Option D

EBIT 15 15 15 15
Less: interest - 1.8(20*9%) 3.0(30*10%) -
EBT 15 13.2 12 15
Less: tax @ 50% 7.5 6.6 6 7.5
EAT/EASH 7.5 6.6 6 7.5
Less: preference dividend 1.5(20*7.5%)
EAESH(A) 7.5 6.6 6 6
No. of equity shares
Existing(40/100) 0.4 0.4 0.4 0.4
NEW 0.4(40/100) 0.2(20/100) 0.1(10/100) 0.2(20/100)
Total (B) 0.8 0.6 0.5 0.6
EPS (A/B) 9.375 11 12 10
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The objective of financial management is to maximize the benefits of equity share holders; since EPS is
maximum it is beneficial to raise the required amount of 40 lakhs by issuing 10,000 equity shares
Rs.100 each and 30 lakhs through long term borrowing with interest 30%.

Problem No.6
Statement of calculation of earnings available to equity holders and debt holders
Company
Particulars
A B
Net operating income 15,00,000 15,00,000
Less: Interest on Debt (11% of Rs.7,00,000) - 77,000
Profit before taxes 15,00,000 14,23,000
Less: Tax @ 25% 3,75,000 3,55,750
Profit after tax/Earnings available in equity holders 11,25,000 10,67,250
Total earnings available to equity holders + Debt holders 11,25,000 10,67,250+77,000
=11,44,250

As we can see that the earnings in case of Company B is more than the earnings of Company A
because of tax shield available to shareholders of Company B due to the presence of debt structure in
Company B. The interest is deducted from EBIT without tax deduction at the corporate level; equity
holders also get their income after tax deduction due to which income of both the investors increase to
the extent of tax saving on the interest paid i.e. tax shield i.e.25% × 77,000 = 19,250 i.e. difference in
the income of two companies’ earnings i.e. 11,44,250– 11,25,000 = Rs.19,250.

Problem No.7
The EPS is determined as follows:
Alternatives
Particulars I II III
(Rs.1,00,000 debt) (Rs.4,00,000 debt) (Rs.6,00,000 debt)
EBIT 1,60,000 1,60,000 1,60,000
Interest 8,000 44,000 74,000
PBT 1,52,000 1,16,000 86,000
Taxes at 50% 76,000 58,000 43,000
PAT 76,000 58,000 43,000
No.of shares 36,000 24,000 20,000
EPS 2.11 2.42 2.15

The second alternative maximizes EPS; therefore, it is the best financial alternative in the present case.
The interest charges for Alternative II and III are calculated as follows:

Interest calculation, Alternative II

Particulars Amount
1,00,000@8% 8,000
3,00,000@12% 36,000
Total 44,000

Interest calculation, Alternative III

Particulars Amount
1,00,000@8% 8,000
4,00,000@12% 48,000
1,00,000@18% 18,000
Total 74,000

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 No.1 for CA/CWA & MEC/CEC MASTER MINDS
The number of shares is found out by dividing the amount to be raised through equity issue by the
market price per share. The market price per share is Rs.25 in case of first two alternatives and Rs.20
in case of last alternative.

Problem No.8
Let X represents level of EBIT at which EPS is same under both the options.
(x − 0)(1 − 35%) = (X − 100LX15%)(1 − 35%)
300L/100 200L/100
⇒ X(65%)
3L
=
(X − 15L)65%
2L
⇒ 2X = 3X-45,00,000
⇒ X = 45,00,000
⇒ EBIT = Rs. 45,00,000

Conclusion: If EBIT is 45lakhs then EPS will be same under both the options i.e., Rs. 9.75 per share.

Problem No.9
Alternatives in financing and its financial charges.
a. By issue of 6,00,000 equity shares of Rs.10 each amounting to Rs.60 lakhs. No financial charges
are involved.
b. By raising the funds in the following way:
Debt = Rs.40 lakhs
Equity = Rs.20 lakhs (2,00,000 equity shares of Rs.10 each)
18
Interest payable on debt =4,00,000X =Rs.7,20,000
100
The difference point between the two alternatives is calculated by:
(EBIT − l1 )(1 − T ) (EBIT − l2 )(1 − T )
=
E1 E2
Where, EBIT = Earning before interest and taxes
I1 = Interest charges in Alternative (a)
I2 = Interest charges in Alternative (b)
T = Tax rate
E1 = Equity shares in Alternative (a)
E2 = Equity shares in Alternative (b)
Putting the values, the break-even point would be as follows:
(EBIT − 0)(1 − 0.40) (EBIT − 7,20,000)(1 − 0.40)
=
6,00,000 2,00,000
(EBIT )(0.60) (EBIT − 7,20,000)(0.60)
=
6,00,000 2,00,000
(EBIT )(0.60) (EBIT − 7,20,000)(0.60)
=
3 1
EBIT = 3EBIT21,60,000
-2 EBIT = 21,60,000
21,60,000
EBIT=
2
EBIT = 10,80,000
Therefore, it can be seen that the EBIT at indifference point explains that the earnings per share for
the two alternatives is equal.

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Problem No.10
i. Computation of EPS under three-financial plans.

Plan 1: Equity Financing

EBIT Rs. 62,500 Rs. 1,25,000 Rs. 2,50,000 Rs. 3,75,000 Rs. 6,25,000
Interest 0 0 0 0 0
EBT Rs. 62,500 Rs. 1,25,000 Rs. 2,50,000 Rs. 3,75,000 Rs. 6,25,000
Less: Taxes 40% 25,000 50,000 1,00,000 1,50,000 2,50,000
PAT Rs. 37,500 Rs. 75,000 Rs. 1,50,000 Rs. 2,25,000 Rs. 3,75,000
No. of equity shares 3,12,500 3,12,500 3,12,500 3,12,500 3,12,500
EPS Rs. 0.12 0.24 0.48 0.72 1.20

Plan 2: Debt – Equity Mix

EBIT Rs. 62,500 Rs. 1,25,000 Rs. 2,50,000 Rs. 3,75,000 Rs. 6,25,000
Interest 1,25,000 1,25,000 1,25,000 1,25,000 1,25,000
EBT (62,500) 0 1,25,000 2,50,000 5,00,000
Less: Taxes 40% 25,000* 0 50,000 1,00,000 2,00,000
PAT (37,500) 0 75,000 1,50,000 3,00,000
No. of equity shares 1,56,250 1,56,250 1,56,250 1,56,250 1,56,250
EPS (Rs. 0.24) 0 0.48 0.96 1.92

The Company will be able to set off losses against other profits. If the Company has no profits from
operations, loses will be carried forward.

Plan 3: Preference Shares – Equity Mix

EBIT Rs. 62,500 Rs. 1,25,000 Rs. 2,50,000 Rs. 3,75,000 Rs. 6,25,000
Interest 0 0 0 0 0
EBT Rs. 62,500 Rs. 1,25,000 Rs. 2,50,000 Rs. 3,75,000 Rs. 6,25,000
Less: Taxes 40% 25,000 50,000 1,00,000 1,50,000 2,50,000
PAT Rs. 37,500 Rs. 75,000 Rs. 1,50,000 Rs. 2,25,000 Rs. 3,75,000
Less: Pref. dividend 1,25,000 1,25,000 1,25,000 1,25,000 1,25,000
PAT for ordinary (87,500) (50,000) 25,000 1,00,000 2,50,000
Shareholders
No. of equity shares 1,56,250 1,56,250 1,56,250 1,56,250 1,56,250
EPS (0.56) (0.32) 0.16 0.64 1.60

ii. The choice of the financing plan will depend on the state of economic conditions. If the company’s
sales are increasing, the EPS will be maximum under Plan II: Debt – Equity Mix. Under favorable
economic conditions, debt financing gives more benefit due to tax shield availability than equity or
preference financing.

iii. EBIT – EPS Indifference Point : Plan I and Plan II

(EBIT *)x(1 − TC ) (EBIT * −Interest )x(1 − TC )

=
N1 N2

EBIT * (1 − 0.40) (EBIT * −1,25,000)x(1 − 0.40)

=
3,12,500 1,56,250

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 No.1 for CA/CWA & MEC/CEC MASTER MINDS
3,12,500
EBIT* = x 1,25,00 = Rs.2,50,000
3,12,500 − 1,56,250
EBIT – EPS Indifference Point: Plan I and Plan III
EBIT * x(1 − TC ) EBIT * (1 − TC ) − Pr ef .Div.
=
N1 N2
N1 Pr ef .Div. 3,12,500 1,25,000
EBIT * = x = x = Rs.4,16,666.67
N1 − N2 1 − TC 3,12,500 − 1,56,250 1 − 0.4

Problem No.11
i. Computation of Earnings per Share (EPS):

Plans P (Rs.) Q (Rs.) R (Rs.)

Earnings before interest & tax (EBIT) 18,00,000 18,00,000 18,00,000
Less: Interest charges - 2,00,000 -
Earnings before tax (EBT) 18,00,000 16,00,000 18,00,000
Less: Tax @ 50% 9,00,000 8,00,000 9,00,000
Earnings after tax (EAT) 9,00,000 8,00,000 9,00,000
Less: Preference share dividend - - 2,00,000
Earnings available for equity shareholders 9,00,000 8,00,000 7,00,000
No. of shares 2,00,000 1,00,000 1,00,000
E.P.S (Rs.) 4.5 8 7

ii. Computation of Financial Break-even Points:

Proposal ‘P’ = 0
Proposal ‘Q’ = Rs.2,00,000 (Interest charges)
Proposal ‘R’ = Earnings required for payment of preference share dividend i.e.
Rs.2,00,000
0.5 (Tax Rate) = Rs.4,00,000

iii. Computation of Indifference Point between the Proposals:

The indifference point
(EBIT - I1 )(1 - T) (EBIT - I2 )(1 - T)
=
E1 E2

Where,
EBIT = Earnings before interest and tax
I1 = Fixed Charges (Interest) under Proposal ‘P’
I2 = Fixed charges (Interest) under Proposal ‘Q’
T = Tax Rate
E1 = Number of Equity shares in Proposal P
2 = Number of Equity shares in Proposal Q

Combination of Proposals:
a. Indifference point where EBIT of proposal “P” and proposal ‘Q’ is equal
(EBIT - 0)(1 − 0.5) (EBIT - 2,00,000)(1 - 0.5)
=
2,00,000 1,00,000
0.5 EBIT (1,00,000) = (0.5 EBIT -1,00,000) 2,00,000
0.5 EBIT = EBIT – 2,00,000
EBIT = Rs. 4,00,000
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b. Indifference point where EBIT of proposal ‘P’ and Proposal ‘R’ is equal:
(EBIT - I1 )(1 - T) (EBIT - I2 )(1 - T)
= - Preference share dividend
E1 E2

(EBIT - 0)(1 - 0.5) (EBIT - 0)(1 - 0.5) - 2,00,000

=
2,00,000 1,00,000
0.5EBIT 0.5EBIT - 2,00,000
=
2,00,000 1,00,000
0.25 EBIT = 0.5 EBIT - 2,00,000
EBIT = 2,00,000 ÷ 0.25 = Rs. 8,00,000

c. Indifference point where EBIT of proposal ‘Q’ and proposal ‘R’ are equal:
(EBIT - 2,00,000)(1 - 0.5) (EBIT - 0)(1 - 0.5) - 2,00,000
=
1,00,000 1,00,000
0.5 EBIT -1,00,000 = 0.5 EBIT – 2,00,000
There is no indifference point between proposal ‘Q’ and proposal ‘R’

Analysis: It can be seen that Financial proposal ‘Q’ dominates proposal ‘R’, since the financial break-
even-point of the former is only Rs. 2,00,000 but in case of latter, it is Rs. 4,00,000.

Problem No.12

Particulars Amount
EBIT 20,00,000
Less: Interest (25,000 x 150 x 14%) 5,25,000
EAESH 14,75,000
Market value of debt = 25,000 x 150 = Rs.37,50,000
EAESH 14,75,000
Market value of equity = = = Rs.92,18,750
Ke 0.16
Market value of firm = Market value of debt + Market value of equity
= 37,50,000 + 92,18,750 = 1,29,68,750
EBIT 20,00,000
Overall cost of capital (Ko) = = = 15.42%
Market value of firm 1,29,68,750

Problem No.13

Firms
Particulars
N M
NOI/EBIT Rs.20,000 Rs.20,000
Debt − Rs.1,00,000
Ke 10% 11.50%
Kd − 7%

NOI − int erest

Value of equity (S) =
cos tofequity
20,000 20,000 − 7,000
sn = =Rs.2,00,000, sm = =Rs.1,13,043
10% 11.50%
Vn= Rs.2,00,000
Vm= 1,13,043 + 1,00,000 {V = S + D} = Rs.2,13,043
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 No.1 for CA/CWA & MEC/CEC MASTER MINDS
Assume you have 10% share of levered company. i.e. M. Therefore, investment in 10% ofequity of
levered company = 10% × 1,13,043 = Rs.11,304.3
Return will be 10% of (20,000 – 7,000) = Rs.1,300.
Alternate Strategy will be:
Sell your 10% share of levered firm for Rs.11,304.3 and borrow 10% of levered firms debt i.e.10% of
Rs.1,00,000 and invest the money i.e. 10% in unlevered firms stock:
Total resources /Money we have = 11,304.3 + 10,000 = 21,304.3 and you invest 10% of2,00,000 =
Rs.20,000
Surplus cash available with you is = 21,304.3 – 20,000 = Rs.1,304.3
Your return = 10% EBIT of unlevered firm – Interest to be paid on borrowed funds
i.e. = 10% of Rs.20,000 – 7% of Rs.10,000 = 2,000 – 700 = Rs.1,300
i.e. your return is same i.e. Rs.1,300 which you are getting from ‘N’ company before investing in

‘M’ company. But still you have Rs.1,304.3 excess money available with you. Hence, you are better off
by doing arbitrage.

Problem No.14
Firms
Particulars
U L
NOI/EBIT Rs. 20,000 Rs. 20,000
Debt − Rs. 1,00,000
Ke 10% 18%
Kd − 7%
 EBIT − Interest  20,000 20,000 − 7,000
Value of equity capital (s) =   = = = Rs. 2,00,000 = Rs. 72,222
 Ke  0.10 0.18
Total value of the firm
V=S+D
Rs. 2,00,000 +Rs. 72,222 + 1,00,000 = Rs. 1,72,222

Assume you have 10% shares of unlevered firm i.e. investment of 10% of Rs. 2,00,000 = Rs.20,000
and Return @ 10% on Rs. 20,000. Investment will be 10% of earnings available forequity i.e. 10% ×
20,000 = Rs. 2,000.

Alternative strategy:
Sell your shares in unlevered firm for Rs. 20,000 and buy 10% shares of levered firm’s equityplus debt
i.e. 10% equity of levered firm = 7,222
10% debt of levered firm = 10,000
Total investment = 17,222
Your resources are Rs. 20,000
Surplus cash available = Surplus – Investment = 20,000 – 17,222 = Rs. 2,778
Your return on investment is:
7% on debt of Rs. 10,000 700
10% on equity i.e. 10% of earnings available for equity holders i.e. (10% × 13,000) 1,300
Total return 2,000
i.e. in both the cases the return received is Rs. 2,000 and still you have excess cash of Rs. 2,778.
Hence, you are better off i.e you will start selling unlevered company shares and buy levered company’s
shares thereby pushing down the value of shares of unlevered firm and increasing the value of levered
firm till equilibrium is reached.
THE END
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