Solved Problems

P.19.1 Assuming no taxes and given the earnings before interest and taxes (EBIT), interest (I) at 10 per cent
and equity capitalisation rate (k ) below, calculate the total market value of each firm.

Firms EBIT I ke (per cent)

X Rs 2,00,000 Rs 20,000 12
Y 3,00,000 60,000 16
Z 5,00,000 2,00,000 15
W 6,00,000 2,40,000 18

Also, determine the weighted average cost of capital for each firm.
Solution
Determination of K0 and V of firms X, Y, Z and W
Particulars X Y Z W
EBIT Rs 2,00,000 Rs 3,00,000 Rs 5,00,000 Rs 6,00,000
Less: Interest 20,000 60,000 2,00,000 2,40,000
Net income for equity-holders 1,80,000 2,40,000 3,00,000 3,60,000
Equity capitalisation rate (ke) 0.12 0.16 0.15 0.18
Market value of equity (S)) 15,00,000 15,00,000 20,00,000 20,00,000
Market value of debt (B) = I/0.10 2,00,000 6,00,000 20,00,000 24,00,000
Total value of firm (V) 17,00,000 21,00,000 40,00,000 44,00,000
Weighted average cost of capital
(k0) = EBIT/V (%) 11.76 14.29 12.5 13.64

P.19.2 Company X and Company Y are in the same risk class, and are identical in every respect except that
company X uses debt, while company Y does not. The levered firm has Rs 9,00,000 debentures, carrying 10
per cent rate of interest. Both the firms earn 20 per cent operating profit on their total assets of Rs 15 lakhs.
Assume perfect capital markets, rational investors and so on; a tax rate of 35 per cent and capitalisation rate
of 15 per cent for an all-equity company.
(a) Compute the value of firms X and Y using the Net Income (NI) Approach.
(b) Compute the value of each firm using the Net Operating Income (NOI) Approach.
(c) Using the NOI Approach, calculate the overall cost of capital (k0) for firms X and Y.
(d) Which of these two firms has an optimal capital structure according to the NOI Approach? Why?
Solution
(a) Valuation under NI approach
Particulars Firm X Firm Y
EBIT Rs 3,00,000 Rs 3,00,000
Less: Interest 90,000 —
Taxable income 2,10,000 3,00,000
Less: Taxes 73,500 1,05,000
Earnings for equity holders 1,36,500 1,95,000
Equity capitalisation rate (ke) 0.15 0.15
Market value of equity (S) 9,10,000 13,00,000
Market value of debt (B) 9,00,000 —
Total value of firm (V) 18,10,000 13,00,000

(b) Valuation under NOI Approach

Rs 3,00,000 (1 0.35 )
VY Rs 13,00,000
0.15
VX = Rs 13,00,000 + Rs 9,00,000 (0.35) = Rs 16,15,000
19.34 Financial Management

Rs 9,00,000 Rs 7,15,000
(c) Kox kd (.065 ) ke ( 0.191 ) = 12.1 per cent
Rs 16,15,000 Rs 16,15,000
Similarly, Koy = 15 per cent
Working Notes
EBIT Rs 3,00,000
Less: Interest 90,000
Taxable income 2,10,000
Less: Taxes 73,500
NI 1,36,500
V as determined in (ii) 16,15,000
B 9,00,000
S (V – B) 7,15,000
Rs 1,36,500
ke = 19.1 per cent
Rs 7,15,000
kd = 0.10 (1–0.35) = 6.5 per cent

(d) Neither firm has an optimum capital structure according to the NOI Approach. Under the MM assumptions,
the optimum capital structure requires 100 per cent debt.
P.19.3 Companies U and L are identical in every respect, except that U is unlevered while L is levered. Com-
pany L has Rs 20 lakh of 8 per cent debentures outstanding. Assume (1) that all the MM assumptions are met,
(2) that the tax rate is 35 per cent, (3) that EBIT is Rs 6 lakh and that equity-capitalisation rate for company
U is 10 per cent.
(a) What would be the value for each firm according to the MM’s Approach?
(b) Suppose Vu = Rs 25,00,000 and Vl = Rs 35,00,000. According to MM do they represent equilibrium values?
If not, explain the process by which equilibrium will be restored.
Solution
EBIT ( 1 t) Rs 6,00,000 (1 0.35 )
(a) Vu Rs 39,00,000
ke 0.10
Vl = Vu + Bt = Rs 39,00,000 + Rs 20,00,000 (0.35) = Rs 46,00,000
(b) Firm U is undervalued and firm L is overvalued. Investors will be better off by investing in the under-
valued firm as they will require lower investment cost to earn the same income as they earn in the
overvalued firm. Therefore, they will sell their holdings of the overvalued firm (L) and buy shares of
the undervalued firm (U). As a result, the price of shares of company L will come down while that of
company U will rise. This process will continue until equilibrium in the values is restored.
P.19.4 In considering the most desirable capital structure of a company, the following estimates of the cost of
debt and equity capital (after tax) have been made at various levels of debt-equity mix:

Debt as percentage of total capital employed Cost of debt (per cent) Cost of equity (per cent)
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
 Capital Structure, Cost of Capital and Valuation 19.35

You are required to determine the optimal debt-equity mix for the company by calculating the composite cost
of capital.
Solution
Solution table
kd (%) ke(%) W1 (B/V) W2 S/V = (1 – B/V) kd(W1) + Ke(W2) = k0(%)
5.0 12.0 0.0 1.0 12.00
5.0 12.0 0.1 0.9 11.30
5.0 12.5 0.2 0.8 11.00
5.5 13.0 0.3 0.7 10.75
6.0 14.0 0.4 0.6 10.80
6.5 16.0 0.5 0.5 11.25
7.0 20.0 0.6 0.4 12.20

Optimal debt-equity mix for the company is at a point where the composite cost of capital is minimum.
When debt is 30 per cent of the total capital employed, the k0 is minimum. Therefore, 30 per cent debt and
70 per cent equity mix would be an optimal debt-equity mix for the company.
P.19.5 A company wishes to determine the optimal capital structure. From the following selected information
supplied to you, determine the optimal capital structure of the company.
Situation Debt Equity After tax cost of debt (%) ke (%)
1 Rs 4,00,000 Rs 1,00,000 9 10
2 2,50,000 2,50,000 6 11
3 1,00,000 4,00,000 5 14

Solution
Situation kd (%) ke (%) W1 (B/V) W2 (S/V) kd(W1) +ke(W2) = k0 (%)
1 9 10 0.8 0.2 9.2
2 6 11 0.5 0.5 8.5
3 5 14 0.2 0.8 12.2

The optimal capital structure for the company is in situation 2, when it uses 50 per cent debt and 50 per
cent equity, as its cost of capital at this level of debt is minimum.
P.19.6 Compute the equilibrium values and capitalisation rates of equity (K) of the companies A and B on the
basis of the following data. Assume that (i) there is no income tax, and (ii) the equilibrium value of average
cost of capital (P) is 8.5 per cent.
Particulars Initial disequilibrium
Company A Company B
Total market value Rs 250 Rs 300
Debt (L) 0 150
Equity (S) 250 150
Expected net operating income (X) 25 25
Interest (K.L) 0 9
Net income (X – K.L) 25 16
Cost of equity (ke) 0.10 0.107
Leverage (L/V) 0 0.5
Average cost of capital (P) 0.10 0.833
19.36 Financial Management

Solution
X Rs 25
(i) The equilibrium values (Ve) = Rs 294.12
P Rs 0.085

(ii) Equity-capitalisation rates for companies A and B

Particulars Company A Company B
Expected net operating income (X) Rs 25 Rs 25
Less: Interest (K.L) — 9
NI available for equity (X – K.L) 25 16
Equilibrium cost of capital (P) 0.085 0.085
Total value of company (X/P) 294.12 294.12
Market value of debt (L) — 150.00
Market value of equity (S) 294.12 144.12
( X K .L )
Cost of equity, 0.085 0.111
S
Alternatively, ke for the levered company B can be determined as follows:
ke = k0 + (k0 – ki) B , ki = 0.06 (Rs 9 interest on Rs 150 debt)
S
Rs 150
= 0.085 + (0.085 – 0.06) 3 0.1111
Rs 144.12
For the unlevered company (A) Ke = k0, as there is no ki.
P.19.7 The values of two firms X and Y in accordance with the traditional theory are given below:
Particulars X Y
__
Expected operating income (X ) Rs 50,000 Rs 50,000
Total cost of __
debt (kd.D = R) 0 10,000
Net income (X – R) 50,000 40,000
Cost of equity (ke) 0.10 0.1111
Market value of shares (S) 5,00,000 3,60,000
Market value of debt (D) 0 2,00,000
Total value of firm (V = S + D) 5,00,000 5,60,000
Average cost of capital (k0) 0.10 0.09
Debt equity ratio 0 0.556

Compute the values of firms X and Y as per the MM thesis. Assume that (i) corporate income taxes do not
exist, and (ii) the equilibrium values of k0 is 12.5 per cent.
Solution
Valuation of firms X and Y
Particulars Company X Company Y
__
Expected operating income (X ) Rs 50,000 Rs 50,000
Total cost of debt (kd.D__ = R) 0 10,000
Net income for equity, X – R 50,000 40,000
Equilibrium cost of capital (k
__ 0) 0.125 0.125
Total value of company = X/k0 4,00,000 4,00,000
Market value of debt (D) — 2,00,000
Market value of equity (V – D) 4,00,000 2,00,000
X R
Cost of equity (ke) = 0.125 0.20
S
 Capital Structure, Cost of Capital and Valuation 19.37

P.19.8 Given (i) the EBIT of Rs 2,00,000, (ii) the corporate tax rate of 35 per cent, and (iii) the following
data, determine the amount of debt that should be used by the firm in its capital structure to maximise the
value of the firm.
Debt ki (before tax) (%) ke(%)
Nil Nil 12.0
Rs 1,00,000 10.0 12.0
2,00,000 10.5 12.6
3,00,000 11.0 13.0
4,00,000 12.0 13.6
5,00,000 14.0 15.6
6,00,000 17.0 20.0

Solution
Valuation of firm at varying amount of debt
EBIT I NI Taxes EAT Kd Ke B S V
(t) (NI – t) (%) (%)
Rs 2,00,000 — Rs 2,00,000 Rs 70,000 Rs 1,30,000 — 12.0 — Rs 10,83,333 Rs 10,83,333
2,00,000 Rs 10,000 1,90,000 66,500 1,23,500 6.5 12.0 Rs 1,00,000 10,29,167 11,29,167
2,00,000 21,000 1,79,000 62,650 1,16,350 6.8 12.6 2,00,000 9,23,413 11,23,413
2,00,000 33,000 1,67,000 58,450 1,08,550 7.1 13.0 3,00,000 8,35,000 11,35,000
2,00,000 48,000 1,52,000 53,200 98,800 7.8 13.6 4,00,000 7,26,471 11,26,471
2,00,000 70,000 1,30,000 45,500 84,500 9.1 15.6 5,00,000 5,41,667 10,41,667
2,00,000 1,02,000 98,000 34,300 63,700 11.0 20.0 6,00,000 3,18,500 9,18,500

The firm should use Rs 3,00,000 debt to maximise the value of the firm.
P.19.9 A company’s current operating income is Rs 4 lakh. The firm has Rs 10 lakh of 10 per cent debt out-
standing. Its cost of equity capital is estimated to be 15 per cent.
(a) Determine the current value of the firm, using traditional valuation approach.
(b) Calculate the overall capitalisation rate as well as both types of leverage ratio:(a) B/S (b) B/V.
(c) The firm is considering increasing its leverage by raising an additional Rs 5,00,000 debt and using the
proceeds to retire that amount of equity. As a result of increased financial risk, ki is likely to go up to
12 per cent and ke to 18 per cent. Would you recommend the plan?
Solution
(a) and (b) Valuation of firm and overall capitalisation rate
EBIT Rs 4,00,000
Less: Interest 1,00,000
Earnings for equityholders (NI) 3,00,000
Equity-capitalisation rate (ke) 0.15
Market value of equity (S) 20,00,000
Market value of debt (B) 10,00,000
Total market value of firm (S + B) 30,00,000
Overall capitalisation rate = EBIT/V 0.1333
(a) Debt/equity ratio (B/S) 0.5
(b) Debt/value ratio (B/V) 0.33

Rs 10,00,000 Rs 20,00,000
Alternatively, k0 = ki(B/V) + ke(S/V) 0.10 0.15 0.1333
Rs 30,00,000 Rs 30,00,000
19.38 Financial Management

(c) Valuation of firm at higher level of debt

EBIT Rs 4,00,000
Less: Interest 1,80,000
Earnings for equity-holders (NI) 2,20,000
Equity-capitalisation rate (ke) 0.18
Market value of equity (S) 12,22,222
Market value of debt (B) 15,00,000
Total market value of firm (S + B) = V 27,22,222

No, we shall not recommend the plan, as the increased proportion of debt would lower the value of the
firm from Rs 30,00,000 to Rs 27,22,222.
P.19.10 The two companies, U and L, belong to an equivalent risk class. These two firms are identical in every
respect except that U company is unlevered while Company L has 10 per cent debentures of Rs 30 lakh. The
other relevant information regarding their valuation and capitalisation rates are as follows:

Particulars Firm U Firm L

Net operating income (EBIT) Rs 7,50,000 Rs 7,50,000
Interest on debt (I) — 3,00,000
Earnings to equityholders (NI) 7,50,000 4,50,000
Equity-capitalisation rate (ke) 0.15 0.20
Market value of equity (S) 50,00,000 22,50,000
Market value of debt (B) — 30,00,000
Total value of firm (S + B) = V 50,00,000 52,50,000
Implied overall capitalisation rate (k0) 0.15 0.143
Debt-equity ratio (B/S) 0 1.33

(a) An investor owns 10 per cent equity shares of company L. Show the arbitrage process and the amount
by which he could reduce his outlay through the use of leverage.
(b) According to Modigliani and Miller, when will this arbitrage process come to an end?
Solution
(a) Arbitrage process
(i) Investor’s current position (in firm L)
Dividend income Rs 45,000
Investment cost 2,25,000
(ii) He sells his holdings of firm L for Rs 2,25,000 and creates a personal
leverage by borrowing Rs 3,00,000 (0.10 3 Rs 30,00,000 debt of firm L).
The total amount with him is Rs 5,25,000. Income required to break even would be:
Dividend income (L firm) 45,000
Interest on personal borrowing (0.10 3 Rs 3,00,000) 30,000
75,000
(iii) He purchases 10 per cent equity holdings of the firm U for Rs 5,00,000.
Dividend income (U firm) (0.10 3 Rs 7,50,000) 75,000
Amount of investment 5,00,000

He will reduce his outlay by Rs 25,000 through the use of leverage.

(b) According to Modigliani and Miller, this arbitrage process will come to an end when the values of both
the firms are identical.
P.19.11 The two companies X and Y belong to the same risk class. They have everything in common except
that firm Y has 10% debentures of Rs 5 lakh. The valuation of the two firms is assumed to be as follows:
 Capital Structure, Cost of Capital and Valuation 19.39

Particulars X Y
Net operating income (EBIT) Rs 7,50,000 Rs 7,50,000
Interest on debt (I) Nil 50,000
Earnings to equityholders (NI) 7,50,000 7,00,000
Equity-capitalisation rate (ke) 0.125 0.14
Market value of equity (S) 60,00,000 50,00,000
Market value of debt (B) — 5,00,000
Total market value of the firm (V) 60,00,000 55,00,000
Implied overall capitalisation rate (k0) 0.125 0.1363
Debt-equity ratio (B/S) 0 0.1

An investor owns 10 per cent of the equity shares of the overvalued firm. Determine his investment cost
of earnings the same income so that he is at a break-even point? Will he gain by investing in the undervalued
firm?
Solution
Arbitrage process
(a) Investor’s position in over valued firm X
Investment cost (0.10 3 Rs 60,00,000) Rs 6,00,000
Dividend income (0.10 3 Rs 7,50,000) 75,000
(b) He sells his holdings in firm X and purchases 10 per cent equity shares
and 10 per cent of debentures of under valued firm Y to earn Rs 75,000.
Investment Income
Shares Rs 5,00,000 Rs 70,000
Debentures 50,000 5,000
5,50,000 75,000

The investment of Rs 5,50,000 earns the same amount of income which he was earning on an investment
of Rs 6,00,000 in the overvalued firm. Clearly, he will gain by investing in the under valued firm Y.
P.19.12 The following is the data regarding two companies ‘X’ and ‘Y’belonging to the same risk class:
Particulars Company X Company Y
Number of ordinary shares 90,000 1,50,000
Market price per share Rs 1.20 1.00
6% Debentures 60,000 —
Profit before interest 18,000 18,000

All profits after debentures interest are distributed as dividends.

Explain how under Modigliani and Miller Approach an investor holding 10 per cent of shares in Company
X will be better off in switching his holdings to Company Y.
Solution
Arbitrage process
(a) Investor’s current position in Firm X with 10 per cent equity holdings:
(i) Investments (9,000 shares 3 Rs 1.20) Rs 10,800
(ii) Dividend income 0.10 3 (Rs 18,000 – Rs 3,600) 1,440
(b) Investor sells his holdings of Firm X for Rs 10,800 and creates a personal
leverage by borrowing Rs 6,000 (0.10 3 Rs 60,000). Thus, the total amount
available with him is Rs 16,800.
(c) He purchases 10 per cent equity holdings of Company Y for Rs 15,000
(15,000 shares 3 Re 1); his dividend income is Rs 1,800 (Rs 18,000 3 0.10).
(Contd.)
19.40 Financial Management

(Contd.)
(d) Gross income 1,800
Less: Interest on personal borrowings (0.06 3 Rs 6,000) 360
Net income 1,440
He breaks-even by investing in Firm Y. But in the process he reduces his
investment outlay by Rs 1,800. Therefore, he is better off by investing in Firm Y.
Alternatively, by investing Rs 16,800, he could augment his income to Rs 1,656:
Rs 16,800
Dividend income from Firm Y Rs 18,000 Rs 2,016
Rs 1,50,000
Less: Interest on personal borrowings 360
Net income 1,656