Subject: Financial Management

Topic: Capital Structure By: Questionscastle Academic Team Document Code: CA/IPCC/FM/00021
Q 1. A firm requires total capital funds of `25 Lacs and has two options available. The first one is all equity while second suggests half equity and half 15% debt. The equity shares can be issued at `100 per share. The EBIT is expected to be `2.50 lacs and tax rate is 40%. Suggest which one is better. Q 2. A company earns a profit of `3,00,000 per annum after meeting its interest liability of `1,20,000 on 12% debt. The equity capital consists of 80,000 equity shares of `10 each and retained earnings amounts to `12,00,000. The company is looking for an expansion scheme which requires a capital of `4,00,000. After expansion the expected return is expected to be same as now. The additional funds can be raised by two methods either by 12% debts or by issuing equity at par. Tax rate is 50%. Calculate EPS. Q 3. X Ltd. a widely hold company is considering an expansion in its business and have following options to select from: Alternative ` in lacs A B C Share Capital 50 20 10 14% Debts 20 15 Loan from bank @ 18% p.a. 10 25 Expected pre tax rate of return is 25%. The rate of dividend is not less than 20%. Tax rate is 50%. Suggest which alternative is better. Q 4. Three financing plans are being considered by ABC Ltd. which requires `10,00,000 for a new plant. It wants to maximize EPS and current market price of share is `30. It has a tax rate of 50% and debts can be arranged as give: Up to `1,00,000 @ 10%, from `1,00,000 to `5,00,000 @ 14%, and `5,00,000 @ 18%. The three financing plans and EBIT are: Plan I: `1,00,000 debt, expected EBIT `2,50,000. Plan II: `3,00,000 debt, expected EBIT `3,50,000. Plan III: `6,00,000 debt, expected EBIT `5,00,000. Calculate EPS under three plans. Q 5. Z Ltd. needs `5,00,000 for its new project. The following three options are available: 1. Issue of 50,000, `10 equity shares. 2. Issue of 25,000, `10 equity shares and 2,500 8% debentures of `100 each. 3. Issue of 25,000, `10 equity shares and 2,500 8% preference shares `100 each. If companys EBIT are `60,000, `40,000, `30,000, what would be its EPS. Also recommend the most suitable plan. Q 6. A furniture company is considering introducing a new product. Plant and inventory expansion equal to 50% of present assets level will be necessary to handle the anticipated volume of new product. Funds are required to be collected for the new project. The company have to proposals to select from: 1. Raise `1,00,000 from 10 year 12% bonds. This will change the capital structure from one with about 20% debt to one with almost 50% debt. Under this method the PE ratio is estimated to reduce from 12:1 to 10:1. 2. Raise `1,00,000 by new common stock i.e. equity. The stock is estimated to be issued at `33.33. The PE ratio is estimated to remain at 12:1. The present market price is `36.

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The recent financial statements of the company are: Balance Sheet as on 31st Dec 2010 Liabilities Assets Amt. ` Common Stock 1,00,000 Plant and Equipment 5% Debt 40,000 Current Assets Retained Earnings 60,000 2,00,000 Income Statement for the same year Sales 6,00,000 Less: Operating Cost (5,38,000) Operating Income 62,000 Less: Interest Charge (2,000) Net Incomes before tax 60,000 Less: Income Tax (30,000) Net Income 30,000

Amt ` 1,35,000 65,000 2,00,000

The company asks you to calculate EPS and market value of the stock (assuming PE ratio is valid) for two proposals assuming total sales (including the new product) of: `4,00,000; `6,00,000; `8,00,000. EBIT is 10% of sales. Also suggest which option is better. Q 7. Icon Furniture Ltd has recently announced its expansion plan by building two new plants to operate in parallel with existing production facility. The expansion will double the assets of the firm. The proposed plan has achieved lots of attention from industry due to cyclic nature of furniture industry and size of the project. The new plants will require fewer workers than current plant of similar facility because of mechanization. Now the question stands in front of the company is of finance. The projects require `50 lacs new funds and expected pre tax return is 12%, the same rate that is currently earned. It has two proposals: 1. Private placement of long term debts of 10% interest rate. 2. Issuance of new equity shares of `25 each at par. Existing capital structure: 8% Long term debt `25,00,000 Common Stock (`1 par) 5,00,000 Retained Earnings 20,00,000 The current market price of the common stock of the company is `27 per share. Tax is levied at 40%. Compute the earnings of the share holders under both proposals. Q 8. Alpha Ltd. is setting up the new project with the capital outlay of `60 lacs. It has two alternatives for financing the project. 1. 100% equity by 6,00,000 equity shares of `10 each. 2. Debt equity ratio of 2:1 which includes 2,00,000 equity shares of `10 each and interest on debt is 18%p.a. Find indifference point when tax rate is 40%. Q 9. Calculate the level of earnings before interest and tax at which the EPS indifference point will occur between the following: Equity share capital of `6,00,000 and 12% debentures of `4,00,000 Or Equity share capital of `4,00,000 12% debentures of `4,00,000 and 14% preference capital of `2,00,000. Tax rate is 35%. Value equity shares at `10 per share. Q 10.Mahakshay Ltd. is considering two financial proposals. Important data are given below. Plan A Plan B Bonds `80,000 at 9% `1,50,000 at 10% Equity Capital 20,000 shares 23,000 shares

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10% preference capital

8,000 shares at `30 each

4,000 shares at `35 each

Assume tax rate is 50% and EBIT is `4,00,000. Determine: EPS for each plan Financial breakeven point At what level of EBIT the indifference point between the plans will be achieved. Q 11.Spyware Softech Ltd. wants to implement a project for which `30 lacs are required. The following financing plans and options are available. Plan A Plan B Plan C (No in thousands) Option 1: Equity Shares 30 30 30 Option 2: Equity shares 15 20 10 12% pref. shares Nil 10 10 10% Non-convertible debts 15 Nil 10 Assume corporate tax is 55% and the face value of all the shares and debentures is `100 each. Calculate indifference point and EPS on each plan. Q 12.B Ltd. has agreed to buy the net assets of A Ltd. (having EBIT of `2,30,000) for `18,00,000. In order to finance the acquisition, the following three proposals are submitted: 1. To issue 5% debentures of `18,00,000 redeemable in 20 years. 2. To issue 5.5% Cumulative Preference Shares of `18,00,000. 3. To issue 60,000 equity shares at a premium of `10 per share. The followings are the balance sheet and income statement of B Ltd. Balance Sheet Liabilities Assets Amt. ` Amt ` Share Capital (Equity 5,00,000 Fixed Assets 20,00,000 shares of `20 each) Revenue Reserves 19,00,000 Current Assets 30,00,000 5% Debentures 10,00,000 Trade Creditors 16,00,000 50,00,000 50,00,000 Income Statement EBIT (-)Interest (-)Tax Profit after Tax (-) Dividend Paid Retained Earnings `12,50,000 50,000 6,00,000 6,00,000 1,25,000 4,75,000

Q 13.A company needs `31,25,000 for establishing a new plant. The following proposals are feasible: 1. The company may issued 3,12,500 equity shares of `10 per share at par. 2. The company may issue 1,56,250 ordinary shares of `10 per share and 15,625 8% debentures of `100 per debenture. 3. The company may issue 1,56,250 equity shares of `10 each and 15,625 preference shares at `100 per shares having 8% dividend payable. A. If the company is having EBIT of `62,500; `1,25,000; `2,50,000; `3,75,000 and `6,25,000, what are the earning per share under each plan. Assume tax rate to be 40%. B. Determine EBIT-EPS indifference point between Plan 1 and Plan 2, Plan 1 and Plan 3.

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Q 14.A Ltd. is formed to produce and sale a single product XML. The total cost of project is estimated to be `5,00,000, to be financed by issue of 2,000 equity shares of `100 each, 1,200 10% preference shares of `100 each and rest by 15% debentures. The sale price of XML is `50 per unit and `30 per unit is its variable cost. Annual Fixed cost stands at `40,000. Find Operating, Financial and overall breakeven point. Tax is 40%. Q 15.Anna Ltd is having a EBIT of `5,00,000. The company has 10%, `20 lac debentures. The equity capitalization rate is 16% (Ke = 16%). Calculate: 1. Market Value of equity shares 2. Value of Firm 3. Overall cost of capital Q 16.Sweetu Ltds operating income is `5,00,000. The firm employs `15,00,000 debt at a cost of 10%. The overall cost of capital is 15%. Calculate: 1. Value of Firm 2. Cost of Equity Q 17.XYZ Ltd. has a total capital of `25,00,000. The firm want to decide its capital structure. The following Data are accumulated by the financial manager of the company: Amount of Debt Interest Rate Equity Capitalization Rate % (at given level of debt) % ` 0 10.00 5,00,000 8.0 10.50 10,00,000 8.0 11.00 15,00,000 9.0 11.50 20,00,000 9.5 12.30 You as Chartered Accountant of the firm required to analyze the data and give the following details: 1. WACC and Optimum capital structure by traditional approach. 2. Equity capitalization rate by Modigliani and Miller approach. Q 18.The following information is available regarding Airfly Ltd.: 1. It has no debt, it is a all equity company. 2. There are no taxes i.e. T=0%. 3. The company pays all its income as dividend. 4. If company started uses debt it can be raised at 8%. This amount is independent of amount of debt used. Any money raised by selling debts will be used to retire common stock, so the company will remain constant. 5. The share holders expect a rate of return of 12% i.e.Ke=12%, if no debt is used. Using MM approach and with no taxes levied at all and assuming a debt of `1 crore, calculate: 1. Firms total market value 2. Firms value of equity Q 19.Bharat and Hindustan Industries have same business risk. Illustrate any arbitrate gains which may be possible using the following data: Bharat Industries Hindustan Industries Market Values: Equity `5,00,00,000 `7,50,00,000 Debt 3,00,00,000 -------`8,00,00,000 `7,50,00,000 Earnings `1,50,00,000 `1,50,00,000 Less: Interest 30,00,000 -------Dividends `1,20,00,000 `1,50,00,000 All earnings are distributed. Assume Mr. X Owns 2% of the equity in bharat industries.

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Q 20.There are two firms P and Q which are identical in every except P is an unlevered firm while Q is a levered firm with `8,00,000 9% debts in its capital structure. Both have EBIT of `2,60,000 p.a. and capitalization rate is 10%. Calculate the value of the both the firms using MM approach, assuming a tax rate of 30%.

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