Financial Management

5 CAPITAL STRUCTURE

SHORT NOTES AND FORMULAE

TERMS MEANING
It refers to the mix of a firm’s capitalization (i.e. mix of long term sources of
1. Capital Structure funds such as debentures, preference share capital , equity share capital and
retained earnings) for meeting total capital requirement.
Financial Structure is the entire left-hand side of the balance sheet which
2. Financial Structure represents all the long-term and short-term sources of capital. Thus, capital
structure is only a part of financial structure.
Optimum capital structure deals with the issue of right mix of debt and equity
in the long-term capital structure of a firm. According to this, if a company
takes on debt, the value of the firm increases up to a certain point. Beyond
3. Optimum Capital
that value of the firm will start to decrease. If the company is unable to pay
Structure
the debt within the specified period then it will affect the goodwill of the
company in the market. Therefore, company should select its appropriate
capital structure with due consideration of all factors.
Indifference point is that level of EBIT at which EPS of different capital
structures remains unchanged. While designing a capital structure, a firm
may evaluate the effect of different financial plans on the levels of EPS, for a
given level of EBIT. Out of several available financial plans, the firm may have
two or more financial plans which results in the same level of EPS for a given
EBIT. Such a level of EBIT at which the firm has two or more financial plans
resulting in same level of EPS, is known as indifference level of EBIT.
EBIT-EPS analysis is a vital tool for designing the optimal capital structure of
a firm. The objective of this analysis is to find the EBIT level that will equate
4. Indifference Point EPS regardless of the financing plan chosen.
(EBIT-EPS EPS of Plan I = EPS of Plan II
relationship) (EBIT-I1)(1-Tax Rate) = (EBIT-I2) (1-Tax Rate)
N1 N2
Where,
EBIT = Indifference point
N1 = Number of equity shares in Alternative 1
N2 = Number of equity shares in Alternative 2
I1 = Interest charges in Alternative 1
12 = Interest charges in Alternative 2
T = Tax-rate
Plan I = All equity finance
Plan II = Debt-equity finance.

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It is a situation where a firm has more capital than it needs or in other words
5. Over-Capitalization assets are worth less than its issued share capital, and earnings are insufficient
to pay dividend and interest.
A business is said to be under-capitalized:
(i) If a company does not have sufficient funds at its disposal to carry on its
activities.
(ii) If the company does not have adequate arrangements for meetings its
6. Under-Capitalization working capital requirement.
(iii) If the current ratio is low & hence liquidity is in danger. Purchases of
materials cannot be made at a proper time. Production is adversely
affected. Finally profitability will be reduced.

This theory was suggested by Durand. The net income (NI) approach to the
relationship between leverage, cost of capital and value of the firm is the
simplest in approach and explanations. This theory states that there is a
relationship between capital structure and the value of the firm and therefore,
7. Net Income (NI) the firm can affect its value by increasing or decreasing the debt proportion in
Approach the overall financing mix.

Both kd and Ke remain constant and increase in financial leverage i.e., use of
more and more debt financing in the capital structure does not affect the risk
perception of the investors.

The Net Operating income (NOI) approach is opposite to the NI approach.

According to the NOI approach, the market value of the firm depends upon
the net operating profit or EBIT and the overall cost of capital, WACC. The
financing mix or the capital structure is irrelevant and does not affect the
value of the firm. The NOI approach makes the following assumptions:
8. Net Operating Income 1. The overall cost of capital, ko, of the firm is constant and depends
Approach (NOI) upon the business risk which also is assumed to be unchanged
Approach 2. The cost of debt, kd, is also taken as constant
3. The uses of more and more debt in the capital structure increases the
risk of the shareholders and thus results in the increase in the cost of
capital i.e., ke. The increase in ke is such as to completely offset the
benefits of employing cheaper debt, and hence the WACC remains
constant.
The NI and the NOI approach hold extreme views on the relationship
between the leverage, cost of capital and the value of the firm. In practical
9. Traditional Approach
situations, both these approaches seem to be unrealistic. The traditional
approach takes a compromising view between the two and incorporates the

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basic philosophy of both. It takes a mid-way between the NI approach and
the NOI approach. The traditional approach makes the following
assumptions:
Both kd and ke tend to rise with increase in financial leverage i.e., use of more
and more debt financing in the capital structure, slowly at first but sharply
thereafter.
Modigliani – Miller derived the following three propositions:
(i) The total market value of a firm and its cost of capital are independent
of its capital structure. The total market value of the firm is given by
10. Modigliani – capitalizing the expected stream of operating earnings at a discount
Miller (MM-I) rate considered appropriate for its risk class.
Approach -1958: (ii) The cost of equity of levered firm is the sum of cost of equity of
Without Tax unlevered firm plus risk premium which is given by the following
equation:
D
Kel = Keu + (Keu − Kd)
E

(iii) Average cost of capital is not affected by financial decision.

In 1963, MM model was amended by incorporating tax, they recognized that
the value of the firm will increase or cost of capital will decrease where
corporate taxes exist. The value of a levered firm will be greater than the value
of the unlevered firm by an amount equal to amount of debt multiplied by
corporate tax rate.
11. Modigliani –
MM has developed the formulae for computation of cost of capital (Ko),cost
Miller (MM-II)
of equity (Ke) for the levered firm.
Approach -1963: With
(i) Value of levered company = Value of an unlevered company + Tax
Tax
Benefit
(ii) Cost of equity in a levered company is given by
Debt
Kel = KeUL + [(KeUL – Kd)X (1 − Tax Rate)]
Equity

(iii) WACC in a levered company (Kol) = Keu(1-t)

The principle implication of this approach is that the cost of capital is
12. Traditional
dependent on the capital structure and there is an optimum capital structure
Approach
which minimizes cost of capital.
The pecking order theory argues against a target debt/equity ratio. The theory
suggests that firms rely for finance as much as they can on internally
13. Pecking Order
generated funds then they will move to additional debt finance and thereafter
Theory
seek to obtain new equity finance. Internally generated funds have the lowest
issue cost & new equity the highest.
Ploughing back of profit means retention of profit & reinvesting it in the
14. Ploughing back company as long term funds. Company plough back of profits every year
of Profits keeping in view the legal requirements in this regard & its own expansion
plans. Such funds entail no financial risk. Also no risk of dilution.

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1. INTRODUCTION
Capital Structure refers to the mix of sources from where the long-term funds required in a business may
be raised. So, it refers to the proportion of Debt, Preference Share Capital, Equity Capital and Retained
Earnings for meeting the total Capital requirement.

2. MAJOR CONSIDERATIONS IN CAPITAL STRUCTURE DECISIONS

The major considerations in Capital Structure Planning can be Risk to the company, Cost to the company,
Control, Tax Savings on Cost, Permanency of the Fund etc. The comparative analysis of different
components of Capital Structure are:
Basis Equity Preference Share Debt
Risk to the Company Low Risk – no question of Slightly higher risk High risk – Capital
repayment of capital except when compared to should be repaid as per
when the company is Equity capital – the agreement, Interest
under liquidation. Hence Principal is redeemable should be paid
best from viewpoint of risk. after a certain period of irrespective of profits.
time even if dividend
payment is based on
profits.
Risk to the Investors High Risk – since they get Slightly less risk as Less Risk – since they
the annual dividend and compared to Equity – get interest and
repayment of capital in case Preference repayment of capital
of liquidation only after the shareholders have before making payment
Preference shareholders preferential right in to Preference and
and Debt holders. terms of payment of Equity. Also interest is
dividend and a charge against profit
repayment of capital. and hence they get
fixed rate of interest
even if the company is
not making any profit.
Cost to the Company Highest Cost – dividend Slightly cheaper than Comparatively cheaper
expectations of cost of equity but – prevailing interest
shareholders are higher higher than Interest rates are considered
than interest rates. Also, rate on Loan funds. only to the extent of
Dividends are not tax Further, Preference after tax impact.
deductible because they are Dividends are not tax- i.e. Interest is charge
appropriations of profits. deductible because against profits and
they are appropriations hence there is tax
of profits. savings.

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Dilution of Control/ Dilution of control – Since No dilution of control No dilution if control –
Ownership the capital base might be since preference but some Financial
expanded and new shareholders generally Institutions may insist
shareholders/ public are do not have voting on nomination of their
involved. right`. representatives as
Directors.
Permanency It is the permanent sources Redeemable or Redeemable or
of funds because equity Irredeemable. Irredeemable.
shares are irredeemable in
nature.

3. CAPITAL STRUCTURE Vs FINANCIAL STRUCTURE

S. No. Capital Structure
1 It refers to only the long term sources of
fund.
2 It excludes current liabilities.
3 Forms part of overall Financial Structure.
Financial Structure
It refers to entire liabilities side of Balance sheet.
It includes current liabilities.
Wider in scope than Capital Structure.

4. FEATURES OF APPROPRIATE CAPITAL STRUCTURE

The following are the major features of an appropriate capital structure:
1. Profitability: Is should minimize the cost of financing and maximize Earnings per Equity Share.
2. Flexibility: The capital structure should be such that the Company can raise funds whenever needed.
3. Conservation: The debt content should not exceed the maximum which the company can bear.
4. Solvency: The capital structure should be such that the Company does not run the risk of becoming
insolvent.
5. Control: There should be minimum risk of loss or dilution of control of the company.

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THEORY PROBLEMS:-
# Question 1:
What do you understand by Capital Structure? How does it differ from financial structure?
OR
What do you mean by Capital Structure? State its significance in financing decision.
Ans: Capital Structure refers to the combination of debt and equity which a company uses to finance its
long-term operations. It is the permanent financing of the company representing long-term sources of
capital i.e. owner’s equity and long-term debts but excludes current liabilities. On the other hand, Financial
Structure is the entire left-hand side of the balance sheet which represents all the long-term and short-term
sources of capital. Thus, capital structure is only a part of financial structure.

# Question 2:
What are the factors determining capital structure?
OR
List the fundamental principles governing capital structure.
Ans: Fundamental Principles Governing Capital Structure are:
(i) Cost Principle: According to this principle, an ideal pattern or capital structure is one that minimizes cost
of capital structure and maximizes earnings per share (EPS).
(ii) Risk Principle: According to this principle, reliance is placed more on common equity for financing
capital requirements than excessive use of debt. Use of more and more debt means higher commitment in
form of interest payout. This would lead to erosion of shareholders value in unfavorable business situation.
(iii) Control Principle: While designing a capital structure, the finance manager may also keep in mind that
existing management control and ownership remains undisturbed.
(iv) Flexibility Principle: It means that the management chooses such a combination of sources of financing
which it finds easier to adjust according to changes in need of funds in future too.
(v) Other Considerations: Besides above principles, other factors such as nature of industry, timing of issue
and competition in the industry should also be considered.

# Question 3:
What is optimum Capital structure? Explain
Ans: Optimum capital structure deals with the issue of right mix of debt and equity in the long-term capital
structure of a firm. According to this, if a company takes on debt, the value of the firm increases up to a
certain point. Beyond that value of the firm will start to decrease. If the company is unable to pay the debt
within the specified period then it will affect the goodwill of the company in the market. Therefore,
company should select its appropriate capital structure with due consideration of all factors.

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# Question 4:
Discuss the major considerations in capital structure planning.
Ans: Major considerations in capital structure planning:
There are three major considerations, i.e. risk, cost of capital and control, which help the finance manager
in determining the proportion in which he can raise funds from various sources.
Although, three factors, i.e., risk, cost and control determine the capital structure of a particular business
undertaking at a given point of time.
Risk: The finance manager attempts to design the capital structure in such a manner, so that risk and cost
are the least and the control of the existing management is diluted to the least extent. However, there are
also subsidiary factors also like − marketability of the issue, maneuverability and flexibility of the capital
structure, timing of raising the funds. Risk is of two kinds, i.e., financial risk and Business risk. Here, we are
concerned primarily with the financial risk. Financial risk also is of two types: • Risk of cash insolvency
• Risk of variation in the expected earnings available to equity share-holders
Cost of Capital: Cost is an important consideration in capital structure decisions. It is obvious that a
business should be at least capable of earning enough revenue to meet its cost of capital and finance its
growth. Hence, along with a risk as a factor, the finance manager has to consider the cost aspect carefully
while determining the capital structure.
Control: Along with cost and risk factors, the control aspect is also an important consideration in planning
the capital structure. When a company issues further equity shares, it automatically dilutes the controlling
interest of the present owners. Similarly, preference shareholders can have voting rights and thereby affect
the composition of the Board of Directors, in case dividends on such shares are not paid for two consecutive
years. Financial institutions normally stipulate that they shall have one or more directors on the Boards.
Hence, when the management agrees to raise loans from financial institutions, by implication it agrees to
forego a part of its control over the company. It is obvious, therefore, that decisions concerning capital
structure are taken after keeping the control factor in mind.

# Question 5:
Discuss the concept of Debt-Equity or EBIT-EPS indifference point, while determining the capital structure
of a company.
Ans: Concept of Debt-Equity or EBIT-EPS Indifference Point while Determining the Capital Structure of a
Company:
The determination of optimum level of debt in the capital structure of a company is a formidable task and
is a major policy decision. It ensures that the firm is able to service its debt as well as contain its interest
cost. Determination of optimum level of debt involves equalizing between return and risk. EBIT – EPS
analysis is a widely used tool to determine level of debt in a firm. Through this analysis, a comparison can
be drawn for various methods of financing by obtaining indifference point. It is a point to the EBIT level at
which EPS remains unchanged irrespective of debt-equity mix. The indifference point for the capital mix
(equity share capital and debt) can be determined as follows:
(EBIT-I1)(1-Tax Rate) = (EBIT-I2) (1-Tax Rate)
N1 N2

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# Question 6:
Write a short note on Financial Break Even & EBIT-EPS indifference Analysis.
Ans: Financial Break-even and EBIT-EPS Indifference Analysis:
Financial break-even point is the minimum level of EBIT needed to satisfy all the fixed financial charges i.e.
interest and preference dividend. It denotes the level of EBIT for which firm’s EPS equals zero. If the EBIT
is less than the financial breakeven point, then the EPS will be negative but if the expected level of EBIT is
more than the breakeven point, then more fixed costs financing instruments can be taken in the capital
structure, otherwise, equity would be preferred.

EBIT-EPS analysis is a vital tool for designing the optimal capital structure of a firm. The objective of this
analysis is to find the EBIT level that will equate EPS regardless of the financing plan chosen.
(EBIT-I1)(1-Tax Rate) = (EBIT-I2) (1-Tax Rate)
N1 N2
Where,
EBIT = Indifference point
N1 = Number of equity shares in Alternative 1
N2 = Number of equity shares in Alternative 2
I1 = Interest charges in Alternative 1
12 = Interest charges in Alternative 2
T = Tax-rate
Alternative 1= All equity finance
Alternative 2= Debt-equity finance.

# Question 7:
“An EBIT-EPS indifference analysis chart is used for determining the impact of a change in sales on EBIT.”
Comment.
Ans: The statement is incorrect as an EBIT-EPS indifference analysis chart is used for examining EPS results
for alternative financing plans at varying EBIT levels.
[Hints: Briefly explain the concept of EBIT-EPS indifference point. Also, state that, impact of change in sales
on EBIT is given by Operating Leverage (OL) or Degree of Operating Leverage (DOL) which is given by
formula:

OL or DOL = % change in EBIT

% change in Sales

# Question 8:
What is Over-Capitalization? State its causes & consequences.
Ans: Overcapitalization and its Causes and Consequences:
It is a situation where a firm has more capital than it needs or in other words assets are worth less than its
issued share capital, and earnings are insufficient to pay dividend and interest.

Causes of Over Capitalization:

Over-capitalization arises due to following reasons:
(i) Raising more money through issue of shares or debentures than company can employ profitably.

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(ii) Borrowing huge amount at higher rate than rate at which company can earn.
(iii)Excessive payment for the acquisition of fictitious assets such as goodwill etc.
(iv) Improper provision for depreciation, replacement of assets and distribution of dividends at a higher
rate.
(v) Wrong estimation of earnings and capitalization.
(Note: Students may answer any two of the above reasons)
Consequences of Over-Capitalization:
Over-capitalization results in the following consequences:
(i) Considerable reduction in the rate of dividend and interest payments.
(ii) Reduction in the market price of shares.
(iii) Resorting to “window dressing”.
(iv) Some companies may opt for reorganization. However, sometimes the matter gets worse and the
company may go into liquidation.
(Note: Students may answer any two of the above consequences)

# Question 9:
What is Under-Capitalization? State its consequences and remedies.
Ans: A business is said to be under-capitalized:
(iv) If a company does not have sufficient funds at its disposal to carry on its activities.
(v) If the company does not have adequate arrangements for meetings its working capital requirement.
(vi) If the current ratio is low & hence liquidity is in danger. Purchases of materials cannot be made at a
proper time. Production is adversely affected. Finally profitability will be reduced.
Consequences of Under-Capitalization:
(i) The dividends rate will be higher in comparison to similar risk class companies.
(ii) The MPS of shares of this company shall be higher than similar risk class companies.
(iii) The MPS shall be higher than the book value per share.
Remedies of Under-Capitalization:
(i) Issue of Bonus shares may be made which will reduce DPS & average EPS.
(ii) The shares of the company may be split up. This will reduce DPS.
(iii) The par value of equity shares may be revised upwards.

# Question 10:
Explain the assumptions of Net Operating Income Approach (NOI) theory of capital structure.
OR
“The level of leverage does not affect the overall capitalization rate & hence the value of firm”. Does this
statement hold true under NOI Theory of capital structure? Explain.
OR
What is Net Operating Income Theory of capital structure? Explain the assumptions on which the NOI
theory is based.

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Ans: According to NOI approach, there is no relationship between the cost of capital and value of the firm
i.e. the value of the firm is independent of the capital structure of the firm.
Assumptions:
(a) The corporate income taxes do not exist.
(b) The market capitalizes the value of the firm as whole. Thus the split between debt and equity is not
important.
(c) The increase in proportion of debt in capital structure leads to change in risk perception of the
shareholders.
(d) The overall cost of capital (Ko) remains constant for all degrees of debt equity mix.

# Question 11:
Explain in brief the assumptions of Modigliani-miller theory.
Ans: Assumptions of Modigliani – Miller Theory
(a) Capital markets are perfect. All information is freely available and there is no transaction cost.
(b) All investors are rational.
(c) No existence of corporate taxes.
(d) Firms can be grouped into “Equivalent risk classes” on the basis of their business risk.

# Question 12:
Discuss the proposition made in Modigliani & Miller approach in capital structure theory.
Ans: Three Basic Propositions made in Modigliani and Miller Approach in Capital Structure Theory:
(i) The total market value of a firm and its cost of capital are independent of its capital structure. The total
market value of the firm is given by capitalizing the expected stream of operating earnings at a discount
rate considered appropriate for its risk class. (ii) The cost of equity (Ke) is equal to capitalization rate of pure
equity stream plus a premium for financial risk. The financial risk increases with more debt content in the
capital structure. As a result, Ke increases in a manner to offset exactly the use of less expensive source of
funds.
(iii) The cut-off rate for investment purposes is completely independent of the way in which the investment
is financed. This proposition along with the first implies a complete separation of the investment and
financing decisions of the firm.

# Question 13:
Explain briefly, Modigliani & Miller approach on cost of capital.
Ans: Modigliani and Miller approach to Cost of Capital: Modigliani and Miller’s argue that the total cost of
capital of a particular corporation is independent of its methods and level of financing. According to them
a change in the debt equity ratio does not affect the cost of capital. This is because a change in the debt
equity ratio changes the risk element of the company which in turn changes the expectations of the
shareholders from the particular shares of the company. Hence they contend that leverages have little effect
on the overall cost of capital or on the market price.
Modigliani and Miller made the following assumptions and the derivations there from:

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Assumptions:
(i) Capital markets are perfect. Information is costless and readily available to all investors, there are no
transaction costs; and all securities are infinitely divisible. Investors are assumed to be rational and to
behave accordingly.
(ii) The average expected future operating earnings of a firm are represented by a subjective random
variable. It is assumed that the expected values of the probability distributions of all investors are the same.
Implied in the MM illustration is that the expected values of the probability distributions of expected
operating earnings for all future periods are the same as present operating earnings.
(iii) Firms can be categorized into “equivalent return” classes. All firms within a class have the same degree
of business risk.
(iv) The absence of corporate income taxes is assumed.

The three basic propositions are:

(i) The total market value of the firm and its cost of capital are independent of its capital structure. The total
market value of a firm is given by capitalizing the expected stream of operating earnings at a discount rate
appropriate for its risk class.
(ii) The expected yield of a share of stock, Ke is equal to the capitalization rate of a pure equity stream, plus
a premium for financial risk equal to the difference between the pure equity capitalization rate and Kg times
the ratio B/S. In other words, Ke increases in a manner to exactly offset the use of cheaper debt funds.
(iii) The cut-off rate for investment purposes is completely independent of the way in which an investment
is financed. This proposition along with the first implies a complete separation of the investment and
financing decisions of the firm.

Conclusion: The theory propounded by them is based on the prevalence of perfect market conditions which
are rare to find. Corporate taxes and personal taxes are a reality and they exert appreciable influence over
decision making whether to have debt or equity.

# Question 14:
Discuss the relationship between the financial leverage & firms required rate of return to equity
shareholders as per Modigliani & Miller Proposition II.
Ans: Relationship between the financial leverage and firm’s required rate of return to equity shareholders
with corporate taxes is given by the following relation:
Kel = Keu+ (Keu- Kel) X D
E
Where,
Kel= Equity capitalization rate of levered firm
Keu= Equity capitalization rate of unlevered firm
(Keu- Kel) X D = Risk premium on account of post-tax debt amount in relation to equity funds.
E

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# Question 15:
Write a short note on Pecking order theory of capital structure.
Ans: The pecking order theory was first proposed by Donaldson in 1961.The pecking order theory argues
against a target debt/equity ratio. The theory suggests that firms rely for finance as much as they can on
internally generated funds. If not enough internally generated funds are available then they will move to
additional debt finance. It is only when these two sources cannot provide enough funds to satisfy needs
that the company will seek to obtain new equity finance. One explanation of this ‘Pecking order’ for the
supply of finance is issue cost. Internally generated funds have the lowest issue cost & new equity the
highest. Firms obtain as much as they can of the easiest & least expensive finance, mainly retained earnings,
before moving to the next least expensive debt.
Assumptions of pecking order theory:
(a) Sticky dividend policy,
(b) A preference for internal funds,
(c) An aversion to issue equity shares.

# Question 16:
Explain the term ‘Ploughing back of Profits’.
Ans: Retained earnings means retention of profit & reinvesting it in the company as long term funds. Such
funds belong to the ordinary shareholders & increase the net worth of the company. A public limited
company must plough back a reasonable amount of profits every year keeping in view the legal
requirements in this regard & its own expansion plans. Such funds entail no financial risk. Also, control of
present owners is also not diluted by retaining profits.

# Question 17:
Indicate whether the following statements are ‘True or False’ and also support your answer with reasons:
i) The advantage of long-term debt from company's viewpoint is that they do not participate in superior
profit and do not participate in the control of the firm.
Ans: True because long-term debt holders do not participate in superior profit and do not participate
in the control of the firm. Common stockholders, however, participate in superior profit and control of
the firm.

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PRACTICAL PROBLEMS:-
# Question 1:
One-up Ltd has equity share capital of Rs. 5,00,000 divided into shares of Rs 100 each. It wishes to raise
further Rs. 300,000 for expansion- cum- modernization scheme. The company plans the following financing
alternatives:
(i) By issuing equity shares only
(ii) Rs. 1,00,000 by issuing shares and Rs. 2,00,000 through debentures or term loan @ 10% per annum.
(iii) By raising term loan at 10% per annum
(iv) Rs. 1,00,000 by issuing equity shares and Rs. 2,00,000 by issuing 8% preference shares.

You are required to suggest the best alternative giving your comment assuming that the estimated ‘Earning
Before Interest and Taxes (EBIT) after expansion is Rs. 1,50,000 and corporate tax rate is 35%.

# Question 2:
Bhaskar Manufactures Ltd. has equity share capital of Rs. 5,00,000 (face value Rs.100). To meet the
expenditure of an expansion programme, the company wishes to raise Rs. 3,00,000 and is having following
four alternative sources to raise the funds:
Plan A: To have full money from the equity shares
Plan B: To have Rs. 1 lakh from equity and Rs. 2 lakhs from borrowing from the financial institutions@10%
p.a.
Plan C: Full money from borrowing@10% per annum.
Plan D: Rs. 1 Lakh in equity and Rs. 2 Lakh from preference shares@8% per annum dividend.

The company is having present earnings (EBIT) of Rs 1,50,000. The corporate tax is 50%. Suggest a suitable
plan of the above four plans to raise the required funds.

# Question 3:
A Company earns a profit of Rs. 3,00,000 per annum after meeting its Interest liability of Rs. 1,20,000 on 12%
debentures. The Tax rate is 50%. The number of Equity Shares of Rs. 10 each are 80,000 and the 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 at the rate of 12% or by issuing Equity Shares at par.
Required:
a. Compute the Earnings Per Share (EPS), if:
Ø the additional funds were raised as debt
Ø the additional funds were raised by issue of equity shares.
b. Advise the company as to which source of finance is preferable.

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Solution:
Computation of EPS
Proposed
Additional Additional
Fund Raised as Fund Raised as
Particulars Existing Debt Equity
EBIT 420,000 (WN 1) 476,000(WN 4) 476,000(WN 4)
Less: Interest on:
Existing Capital 120,000 120,000 120,000
New Capital - 48,000 -
EBT 300,000 308,000 356,000
Less: Tax@50% 150,000 154,000 178,000
EAT 150,000 154,000 178,000
Less: Preference Dividend - - -
Earnings available for Equity
Shareholder (a) 150,000 154,000 178,000
No. of Equity Share (b) 80,000 80,000 120,000
EPS [(a)/(b)] 1.88 1.925 1.48
Working Notes:
1. Capital Employed in Existing plan:
Particulars Amount
Equity shares 800,000
Debentures (Rs. 1,20,000/12) × 100 1,000,000
Retained earnings 1,200,000
Total capital employed 3,000,000

2. Computation of EBIT
Particulars Amount
Profit 300,000
Interest 120,000
Total capital employed 420,000

3. Return on Investment (ROI):

EBIT 4,20,000
ROI = X 100% = X 100% = 14%
Capital Employed 30,00,000

4. EBIT after the Expansion:

Capital Employed after expansion = Rs. 34,00,000
Desired EBIT = Rs. 34,00,000 X 14% = Rs. 4,76,000

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# Question 4:
A company’s capital structure consists of the following:
(Rs. In Lakhs)
Equity shares of Rs 100 each 20
Retained Earnings 10
9% Preference Shares 12
7% Debentures 8
Total 50
The company’s Earnings Before Interest and tax (EBTI) is at the rate of 12% on its capital employed, which
is likely to remain unchanged after expansion. The expansion involves additional finance of Rs 25 lakhs for
which the following alternatives are available to it:
(I) Issue of 20,000 equity shares at a premium of Rs.25 per share.
(II) Issue of 10% preference shares
(III) Issue of 8% debentures
It is estimated that P/E ratio in the case of equity shares, pref. shares and debentures financing would be
21.4, 17 and 15.7 respectively. Which of these alternatives of financing would you recommend & why?
Income Tax rate is 50%.

# Question 5:
A company needs Rs. 12,00,000 for the installation of a new factory, which would yield annual EBIT of Rs.
2,00,000. The company has the objective of maximizing the earnings per share. It is considering the
possibility of issuing equity shares plus raising a debt of Rs. 2,00,000, Rs. 6,00,000 or Rs. 10,00,000. The
current market price per share is Rs 40, which is expected to drop to Rs 25 per share if the market borrowings
were to exceed Rs 7,50,000.
Cost of borrowings are indicated as under:
Up to Rs. 2,50,000 10% p.a.
Between Rs. 2,50,001 and Rs. 6,50,000 14% p.a.
Between Rs. 6,50,001 and Rs. 10,00,000 16% p.a.
Required:
a. Assuming the tax rate to be 50% work out the EPS and the scheme, which would meet the objective of
the management.

# Question 6:
A new project under consideration requires a capital outlay of Rs. 300 Lakh for which the funds can either
be raised by the issue of equity shares of Rs. 100 each or by the issue of equity shares of the value of Rs. 200
Lakh and by the issue of 15% loan of Rs. 100 Lakh. Find out the indifference level of EBIT given the tax rate
at 50%.

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# Question 7:
Growell Corporation has decided to change its capital structure. The firm currently has one crore fully paid
up shares. The share commands a price of Rs. 50 in the market and is likely to remain the same even after
proposed capital restructuring. The restructuring involves increasing the firm’s existing Rs. 9 Crore 10%
debt to Rs. 14 Crore. The proceeds will be used to retire the equity. The interest rate on debt is not expected
to change as the debt investors do not perceive the firm to become more risky as a result of proposed
increase in debt. Company is in tax bracket of 40%. Keeping in mind EPS-EBIT relationship in the context
of capital structure, calculate the minimum level of EBIT that the firm must earn so that EPS does not change.

# Question 8:
A new project is under consideration in Zip Ltd., which requires a capital investment of Rs. 4.50 crore.
Interest on term loan is 12% and Corporate Tax rate is 50%. If the Debt Equity ratio insisted by the financing
agencies is 2 : 1, calculate the point of indifference for the project.
Solution:
At Indifference point;
EPS of Equity Plan = EPS of Debt & Equity Plan

EBIT (1 − Tax) (EBIT − Interest) (1 − Tax)

Or, =
N1 N2

EBIT (1 − Tax) (EBIT − 36,00,000) (1 − Tax)

Or, =
4.5 Lakhs 1.5 Lakhs

EBIT (1 − Tax) (EBIT − 36,00,000) (1 − Tax)

Or, =
4.5 Lakhs 1.5 Lakhs

Or, EBIT = 3 EBIT – 108,00,000

Hence, EBIT = 54,00,000

# Question 9:
Calculate the level of earnings before interest and tax (EBIT) at which the EPS indifference point between
the following financing alternatives will occur.
(i) Equity share capital of Rs.6,00,000 and 12% debentures of Rs.4,00,000
Or
(ii) Equity share capital of Rs.4,00,000, 14% preference share capital of Rs.2,00,000 and 12% debentures of
Rs.4,00,000.
Assume the corporate tax rate is 35% and par value of equity share is Rs.10 in each case.
Solution:
Calculation of the level of EBIT) at which the EPS indifference point exist.
At Indifference point;

EPS of Plan (i) = EPS of Plan (ii)

(EBIT − Interest) (1 − Tax) (EBIT − Interest)(1 − Tax) − Pref. Dividend

Or, =
N1 N2

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(EBIT − 4,00,000 X 12%) (1 − 0.35) (EBIT − 4,00,000 X 12%)(1 − 0.35) − 2,00,000 X 12%
Or, =
60,000 40,000

(0.65EBIT − 31,200) (0.65EBIT − 59,200)

Or, =
3 2

Or, 1.30 EBIT – 62,400 = 1.95 EBIT – 1,77,600

1,15,200
Or, EBIT =
0.65

Or, EBIT = 1,77,231

# Question 10:
The following current data are available concerning Theta Limited:
Share issued 10,000
Market price per share Rs. 20
Interest rate 12%
Tax Rate 46%
Expected EBIT Rs.15,000
The company requires an additional Rs 50,000 for the coming year.
You are required to determine:
(i) Which financing option (debt or equity issue) will give higher EPS for the expected EBIT?
(ii) What is indifference level of EBIT for the two alternatives?
(iii) What is EPS for that EBIT?
Solution:
(i) Computation of EPS at Debt and Equity Plan
Particulars Debt Equity
Expected EBIT 15,000 15,000
Less: Interest [Rs. 50,000 X 12%] 6,000 -
EBT 9,000 15,000
Less: Tax@46% 4,140 6,900
EAT 4,860 8,100
Less: Preference Dividend - -
Earnings available for Eq. Shareholders (a) 4,860 8,100
No. of Equity shares issued (b) 10,000 12,500
EPS 0.486 0.648

Hence, it can be noticed that EPS is higher if the fresh issue is made through Equity Shares.

Working Notes:
1. Number of new shares to be issued:
Amount of Funds required (A) Rs. 50,000
Market Price per share (B) Rs. 20

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No. of new shares to be issued (A/B) 2,500

(ii) Computation of indifference point between two plans namely Debt and Equity.
At Indifference point;
EPS of Equity Plan = EPS of Debt

EBIT (1 − Tax) (EBIT − Interest) (1 − Tax)

Or, =
N1 N2

EBIT (1 − 0.46) (EBIT − 6,000) (1 − 0.46)

Or, =
12,500 10,000

Or, EBIT = Rs. 30,000

Hence, Indifference level of EBIT for two alternatives is Rs. 30,000

(iii)
EBIT (1 − 0.46)
EPS =
12,500

= Rs. 1.296 per share

# Question 11:
Theta Limited has a total capitalization of Rs 10 Lakhs consisting entirely of equity shares of Rs.50 each. It
wishes to raise another Rs 5 lakhs for expansion through one of its two possible financial plans.
(1) All equity shares of Rs 50 each.
(2) All debentures carrying 9% interest.
The present level of EBIT is Rs 1,40,000 and Income tax rate is 50%.
Calculate EBIT level at which earnings per share would remain the same irrespective of raising funds
through equity shares or debentures.
Solution:
Calculation of EBIT level at which earnings per share would remain the same

EPS of Equity Plan = EPS of Debt

EBIT (1 − Tax) (EBIT − Interest) (1 − Tax)

Or, =
N1 N2

EBIT (1 − 0.50) (EBIT − 45,000) (1 − 0.50)

Or, =
20,000 + 10,000 20,000

Or, 2 EBIT = 3 EBIT − 1,35,000

Or, EBIT = 1,35,000

At EBIT level of Rs. 1,35,000 earnings per share in both cases will be equal

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# Question 12:
The management of Z Company Ltd. wants to raise its funds from market to meet out the financial demands
of its long-term projects. The company has various combinations of proposals to raise its funds. You are
given the following proposals of the company:
(i)
Proposals % of Equity % of Debts % of Preference shares
P 100 - -
Q 50 50 -
R 50 - 50
(ii) Cost of debt – 10%, Cost of preference shares – 10%
(iii) Tax rate – 50%
(iv) Equity shares of the face value of Rs. 10 each will be issued at a premium of Rs. 10 per share.
(v) Total investment to be raised Rs. 40,00,000.
(vi) Expected earnings before interest and tax Rs. 18,00,000.
From the above proposals the management wants to take advice from you for appropriate plan after
computing the following:
Ø Earnings per share
Ø Financial break-even-point
Ø Compute the EBIT range among the plans for indifference. Also indicate if any of the plans
dominate.

# Question 13:
A Company needs Rs. 31,25,000 for the construction of new plant. The following three plans are feasible:
I. The Company may issue 3,12,500 equity shares at Rs. 10 per share.
II. The Company may issue 1,56,250 ordinary equity shares at Rs. 10 per share and 15,625 debentures
of Rs,. 100 denominations bearing a 8% rate of interest.
III. The Company may issue 1,56,250 equity shares at Rs. 10 per share and 15,625 preference
shares at Rs. 100 per share bearing a 8% rate of dividend.
(i) If the Company's earnings before interest and taxes are Rs. 62,500, Rs. 1,25,000, Rs. 2,50,000, Rs.
3,75,000 and Rs. 6,25,000, what are the earnings per share under each of three financial plans ?
Assume a Corporate Income tax rate of 40%.
(ii) Which alternative would you recommend and why?
(iii) Determine the EBIT-EPS indifference points by formulae between Financing Plan (a) and Plan (b)
and Plan (a) and Plan (c).

Solution:
(i) Computation of EPS under three-financial plans
Plan I: Equity Financing
EBIT 62,500 125,000 250,000 375,000 625,000
Interest - - - - -
EBT 62,500 125,000 250,000 375,000 625,000
Less: Taxes 40% 25000 50000 100000 150000 250000
PAT 37,500 75,000 150,000 225,000 375,000
No. of Equity Shares 312,500 312,500 312,500 312,500 312,500
EPS 0.12 0.24 0.48 0.72 1.20

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Plan II: Debt – Equity Mix

EBIT 62,500 125,000 250,000 375,000 625,000
Interest 125,000 125,000 125,000 125,000 125,000
EBT (62,500) - 125,000 250,000 500,000
Less: Taxes 40% 25,000* - 50,000 100,000 200,000
PAT (37,500) - 75,000 150,000 300,000
No. of Equity Shares 156,250 156,250 156,250 156,250 156,250
EPS -0.24 0.00 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, losses will be carried forward.

Plan III: Preference Shares – Equity Mix

EBIT 62,500 125,000 250,000 375,000 625,000
Interest - - - - -
EBT 62,500 125,000 250,000 375,000 625,000
Less: Taxes 40% 25,000 50,000 100,000 150,000 250,000
PAT 37,500 75,000 150,000 225,000 375,000
Less: Pref. dividend 125,000 125,000 125,000 125,000 125,000
EAE (87,500) (50,000) 25,000 100,000 250,000
No. of Equity Shares 156,250 156,250 156,250 156,250 156,250
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(1-Tax Rate) = (EBIT-Interest)(1-Tax Rate)
N1 N2

EBIT(1-0.40) = (EBIT-1,25,000)(1-0.40)
3,12,500 1,56,250

EBIT = 3,12,500 X 1,25,000 = Rs. 2,50,000

3,12,500-1,56,250

EBIT – EPS Indifference Point: Plan I and Plan III

EBIT(1-Tax Rate) = EBIT(1-Tax Rate)–Pref. Div.
N1 N2

EBIT(1-0.40) = EBIT(1-0.40)-1,25,000
3,12,500 1,56,250
By CA Subash Poudel Page 158
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EBIT = Rs. 4,16,666.67

# Question 14:
Happy-Day Industries Inc. is financed by entirely with 100,000 shares of common stock selling at Rs 50 per
share. The firm’s EBIT is expected to be Rs 4,00,000. The firm pays 100% of its earnings as dividends.
(a) Using the NI approach, compute the total value of the firm, cost of equity and overall cost of capital
(b) The company has decided to retire Rs 1 Million of common stock, replacing it with 6% long term
debt. Compute the total value of firm and the overall cost of capital after refinancing.

# Question 15:
(a) ABC Ltd. is expecting an annual Earnings before the payment of Interest and Tax of Rs. 2,00,000.
The company in its capital structure has Rs 8,00,000 in 10% debentures. The cost of equity or equity
capitalization rate is 12.5%. You are required to calculate the value of the firm according to NI
approach. Also compute the overall cost of capital.
(b) Assume in the above question that the firm decide to raise further Rs 2,00,000 by the issue of
debentures and to use the proceeds thereof to redeem the equity shares. You are required to calculate
the value of the firm according to NI approach. Also compute the overall cost of capital.

# Question 16:
ABC Ltd. is expecting an Earnings before interest & tax of Rs. 4,00,000 and belongs to risk class of 10%. You
are required to find out the value of the firm & cost of equity capital according to NOI approach if it employs
8% debt to the extent of 20%, 35% or 50% of the total financial requirement of Rs. 20,00,000.

# Question 17:
DEF Ltd .is expecting an Earnings before interest & tax of Rs. 4,00,000 and is an all equity company.
(a) Using the NOI approach and an overall cost of capital of 10%, compute the total value, the stock
market value of the firm, and the cost of equity.
(b) Determine the answers to (a) if the company decided to retire Rs. 1 Million of common stock,
replacing it with 9% long term debt.

# Question 18:
Amita Ltd’s operating income (before interest and tax) is Rs 9,00,000.00. The firm’s cost of debt is 10% and
currently the firm employs Rs 30,00,000 of debts. The overall cost of capital of the firm is 12%. You are
required to determine:
(i) Total value of firm
(ii) Cost of equity
Solution:
Particulars Amount (In Rs.)
EBIT 900,000
Less: Interest (Rs. 30,00,000@10%) 300,000
EBT 600,000

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EBIT 9,00,000
Value of Firm = = = Rs. 75,00,000
Ko 12%

Value of Equity = Value of Firm – Value of Debt = Rs. 75,00,000- Rs. 30,00,000 = Rs. 45,00,000

EBT 6,00,000
Ke = = = 13.33%
Value of Equity 45,00,000

# Question 19:
XYZ Ltd. is expecting an EBIT of Rs. 3,00,000. The company presently raised its entire fund requirement of
Rs. 20 Lakhs by issue of equity capitalization rate of 16%. The firm is now contemplating to redeem a part
of capital by introducing debt financing. The firm has two options- to raise debt to the extent of 30% or 50%
of total funds. It is expected that for debt financing upto 30%, the rate of interest will be 10% and equity
capitalization rate is expected to increase to 17%. However, if firm opts for 50% debt than interest rate will
be 12% and equity capitalization rate will be 20%. You are required to compute value of firm and its overall
cost of capital under different options if the traditional approach is held valid.

# Question 20:
Sonam ltd has a total capital of Rs 1000000. The financial manager of the firm wants to take decision
regarding the capital structure. After a study of the capital market, he gathers the following data:
Debt Interest rate % Ke%
0 - 10
100000 4 10.5
200000 4 11
300000 4.5 11.6
400000 5 12.4
500000 5.5 13.5
600000 6 16
(a) What amount of debt should the firm apply if the traditional approach is held valid?
(b) If MM approach is applied what should be the equity capitalization rate.

# Question 21:
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 90000 150,000
Market price per share (Rs.) 1.2 1
6% Debentures(Rs.) 60000 --
Profit before interest(Rs.) 18000 18000

All profits after debenture interest are distributed as dividends.

Explain how under Modigliani& Miller approach, an investor holding 10% of shares in company X will be
better off in switching his holding to company Y.

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# Question 22:
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 90000 150,000
Market price per share (Rs.) 1.00 1.20
6% Debentures(Rs.) 60000 --
Profit before interest(Rs.) 18000 18000
All profits after debenture interest are distributed as dividends.
Explain how under Modigliani& Miller approach, an investor holding 10% of shares in company Y will be
better off in switching his holding to company X.
Solution:
Value of Firm
Particulars Company X Company Y
Value of Equity (VE) 90,000 180,000
Value of Debt (VD) 60,000 -
Value of Firm (VF) 150,000 180,000
Investor will sale 10% of shares of Company Y for Rs. 18,000.

18,000
% of Debt & Equity to be purchased = X 100% = 12%
1,50,000

After 1 Year:
Particulars Amount (In Rs.)
Interest receivable on debt [(12% of Rs. 60,000) X 6%] 432
Add: Dividend Income [(18,000-3600) X 12%] 1,728
Net Income from Company X 2,160
Less: Income from Company Y 1800
Arbitrage Gain 360

# Question 23:
Companies U and L are identical in every respect except that the former does not use debt in its capital
structure, while the latter employs Rs. 6,00,000 of 15% debt. Assuming that (a) all the MM assumptions are
met, (b) the corporate tax rate is 50%, (c) the EBIT is Rs. 2,00,000 and (d) the equity capitalization of the
unlevered company is 20%, what will be the value of the firms, U and L ? Also determine the weighted
average cost of capital for both the firms.

# Question 24:
RES Ltd. is an all equity financed company with a market value of Rs 25,00,000 and cost of equity, Ke=21%.
The company wants to buyback equity shares of Rs. 5,00,000 by issuing and raising 15% perpetual debt of
the same amount. Rate of tax may be taken as 30%. After the capital restructuring and applying MM Model
(with taxes), you required to calculate:
(i) Market value of RES Ltd.
(ii) Cost of Equity Ke.
(iii) Weighted Average cost of capital and comment on it.

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Solution:
Computation of Market Value, Cost of Equity and WACC of RES Ltd.
Market Value of Equity = Rs. 25,00,000
Ke = 21%
Net Income for Equity Dhareholder
Market Value of Equity =
Ke

Net Income for Equity Dhareholder

25,00,000 =
21%

Net Income for Equity Shareholders (EAT) = Rs. 5,25,000

EAT = (EBIT – Interest) X (1-Tax Rate)

5,25,000 = (EBIT – 0) X (1-0.30)

5,25,000
EBIT = = Rs. 7,50,000
0.70

Particulars All Equity (Rs.) Debt and Equity (Rs.)

EBIT 750,000 750,000
Less: Interest on Debt - 75,000
EBT 750,000 675,000
Less: Tax @30% 225,000 202,500
Earnings available for Equity Shareholders 525,000 472,500
Present value of tax-shield benefits = Rs. 5,00,000 X 0.30 = Rs. 1,50,000
i. Value of Levered Firm = Rs. 25,00,000 + Rs. 1,50,000 = Rs. 26,50,000
ii. Cost of Equity (Ke):
Total Value of Firm Rs. 26,00,000
Less: Value of Debt (Rs. 5,00,000)
Value of Equity Rs. 21,50,000

Net Income for Equity Dhareholder

Market Value of Equity =
Ke

4,72,500
Ke = = 21.90%
21,50,000

iii. Computation of WACC

Cost of Debt (After Tax) = 15% (1-0.30) = 10.50%
Amount (In
Sources Rs.) Weight (a) Cost (b) (a) X (b)
Equity 2,150,000 0.81 22% 17.82%
Debt 500,000 0.19 10.50% 2%
2,650,000 1.00 WACC 19.82%

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# Question 25:
There are two firms P and Q which are identical except P does not use any debt in its capital structure while
Q has Rs. 8,00,000, 9% debentures in its capital structure. Both the firms have earnings before interest and
tax of Rs. 2,60,000 p.a. and the capitalization rate is 10%. Assuming the corporate tax of 30%, calculate the
value of these firms according to MM Hypothesis.
Solution:
Market Value of Firm P (Unlevered):
EBIT (1 − Tax Rate) Rs. 2,60,000 (1 − 0.30)
Vu = =
Keu 10%

Rs. 1,82,000
= = Rs. 18,20,000
10%

Market Value of Firm Q (Levered):

VL = Vu + D X Tax Rate
= Rs. 18,20,000 + (Rs. 8,00,000 X 0.30)
= Rs. 18,20,000 + Rs. 2,40,000
= Rs. 20,60,000

# Question 26:
The Evergreen Company has the choice of raising an additional sum of Rs. 50,00,000 either (i) by issue of
10% debentures, or (ii) issue of additional equity shares @ Rs. 50 per share. Presently, the capital structure
of the firm does not consist of any debt and the company has issued 10,00,000 equity shares only. At what
level of EBIT, after the new capital funds are acquired, would the EPS be the same under different
alternative financing plans. Also determine the level of EBIT at which uncommitted earnings per share
(UEPS) would be the same, if the sinking fund obligations amounting to Rs. 5,00,000 in respect of debenture
issue is to be made every year. Tax rate may be assumed at 50% and also verify the result.
Solution:
EBIT – EPS Indifference Point :Equity Plan and Debt & Equity Plan
EBIT(1 − Tax Rate) (EBIT − Interest)(1 − Tax Rate)
=
N1 N2

EBIT(1 − 0.50) (EBIT − 5,00,000)(1 − 0.50)

=
11,00,000 10,00,000

EBIT = Rs. 55,00,000

Verification:
Under Equity Plan:
Rs. 55,00,000(1 − 0.50)
EPS = = Rs. 2.50
11,00,000

OR,

Under Debt &Equity Plan:

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(Rs. 55,00,000 − Rs. 5,00,000)(1 − 0.50)
EPS = = Rs. 2.50
10,00,000

Indifference Point in UEPS:

EBIT(1 − 0.50) (EBIT − 5,00,000)(1 − 0.50) − 5,00,000
=
11,00,000 10,00,000

EBIT = Rs. 1,65,00,000

Verification:
Under Equity Plan:
Rs. 1,65,00,000(1 − 0.50)
UEPS = = Rs. 7.50
11,00,000

OR,

Under Debt &Equity Plan:

(Rs. 1,65,00,000 − Rs. 5,00,000)(1 − 0.50)

EPS = = Rs. 7.50
10,00,000

# Question 27:
A Ltd is formed to produce and sale a single product X. The total cost of the project is estimated at Rs.5,00,00,
to be financed by issue of 2,000 ordinary shares of Rs. 100 each, 1,200 10% preference shares of Rs. 100 each
and the rest by the issue of 15% Debentures. The unit sale price and variable cost of X are Rs.50 and Rs.30
respectively. Annual fixed cost is Rs.40,000. Corporate tax rate is 40%. Find operating, financial and overall
break even points.

Solution:
Operating Fixed Cost
Operating BEP =
Contribution per unit

40,000
= = 2,000 Units
Rs. 50 − Rs. 30

Preference Dividends
Financial BEP = Interest +
1 − Tax

12,000
= 27,000 + = Rs. 47,000
1 − 0.40

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Operating Fixed Cost + Interest + Preference Dividend/(1 − Tax)
Overall BEP =
Contribution per unit

40,000 + 27,000 + 12,000/(1 − 0.40)

= = 4,350 Units
20

# Question 28:
Equipment Company has earnings before interest and taxes (EBIT) of Rs. 10 million. The company currently
has outstanding debt of Rs. 20 million at a cost of 7%.
(a) Using the net income (NI) approach and a cost of equity of 12.5%; (1) compute the total value of the firm
and firm's overall weighted average cost of capital (Ko) and (2) determine the firm's market debt/equity
ratio.
(b) Assume that the firm issues an additional Rs. 10 million in debt and uses the proceeds to retire stock;
the interest rate and the cost of equity remain the same. (1) Compute the new total value of firm and the
firm's overall cost of capital and (2) determine the firm's market debt/equity ratio.
Solution:
(a) Using the Net Income Approach:
EBIT = Rs. 10,000,000
Interest = Rs. 20,000,000 X 7% = Rs. 14,00,000
Ke = 12.50%

(1) Total Value of the Firm (VF) = Value of Equity (VE) + Value of Debt (VD)
EAE = EBIT – I = Rs. 10,000,000 – Rs. 14,00,000 = Rs. 86,00,000
EAE 86,00,000
Value of Equity = = = Rs. 6,88,00,000
Ke 12.50%

VF = VE + VD = 6,88,00,000 + 20,000,000 = 8,88,00,000

EBIT 10,000,000
Hence, Ko = = = 11.26%
Value of Firm 8,88,00,000

(2) The firm’s market debt/equity ratio is:

Value of Debt 20,000,000
= = = 0.2907
Value of Equity 6,88,00,000

(b)
(1) Interest = Rs. 30,000,000 X 7% = Rs. 21,00,000
EAE = EBIT – I = Rs. 10,000,000 – Rs. 21,00,000 = Rs. 79,00,000
EAE 79,00,000
Value of Equity = = = Rs. 6,32,00,000
Ke 12.50%

VF = VE + VD = 6,32,00,000 + 30,000,000 = 9,32,00,000

EBIT 10,000,000
Hence, Ko = = = 10.73%
Value of Firm 9,32,00,000

(2) The firm’s market debt/equity ratio is:

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Value of Debt 30,000,000
= = = 0.4747
Value of Equity 6,32,00,000

# Question 29:
Company XYZ is unlevered and has a cost of equity of 20 percent and a total market value of Rs. 10, 00,
00,000. Company ABC is identical to XYZ in all respects except that it uses debt finance in its capital
structure with a market value of Rs. 4,00,00,000 and a costof 10 percent. Find the market value of equity,
weighted average cost of capital and cost of equity of ABC if the tax advantage of debt is 25 percent.
Solution:
Market Value of Company ABC is:
VABC = VXYZ + Market Value of Debt X Tax Rate
= Rs. 10,00,00,000 + 4,00,00,,000 X 25% = 11,00,00,000

For Company ABC:

Market Value of Equity:

VE = VF – VD
= Rs. 11,00,00,000 – Rs. 4,00,00,000 = Rs. 7,00,00,000

WACC of Company ABC:

Market Value of Debt X Tax Rate
WACC of ABC = WACC 0f XYZ [1 − ]
Value of ABC

4,00,000 X 25%
= 20% g1 − h = 18.18%
11,00,000
Cost of Equity of ABC:
Debt
= KeUL + [(KeUL – Kd)X (1 − Tax Rate)]
Equity

4,00,000
= 20% + g(20% – 10%)X (1 − 25%)h = 24.28%
7,00,000

# Question 30:
The following figures of Theta Limited are presented as under:
Rs.
Earnings before Interest and Tax 23,00,000
Less: Debenture Interest @ 8% 80,000
Long Term Loan Interest @ 11% 2,20,000 3,00,000
20,00,000
Less: Income Tax 10,00,000
Earnings after tax 10,00,000

No. of Equity Shares of Rs 10 each 5,00,000

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 Financial Management
EPS Rs 2
Market Price of Share Rs 20
P/E Ratio 10
The company has undistributed reserves and surplus of Rs 20 lakhs. It is in need of Rs 30lakhs to pay off
debentures and modernize its plants. It seeks your advice on thefollowing alternative modes of raising
finance.
Alternative 1 - Raising entire amount as term loan from banks @ 12%.
Alternative 2 - Raising part of the funds by issue of 1,00,000 shares of Rs 20 each and the rest by term
loan at 12 percent.
The company expects to improve its rate of return by 2 percent as a result of modernization, but P/E ratio
is likely to go down to 8 if the entire amount is raised as term loan.
(i) Advise the company on the financial plan to be selected.
(ii) If it is assumed that there will be no change in the P/E ratio if either of the two alternatives is adopted,
would your advice still hold good?
Solution:
Computation of Existing Capital employed:
Particulars Working Amount
Equity Share Capital 5,00,000 Shares @ Rs.10 5,000,000.00
Interest Amount 80,000
Debentures = 1,000,000.00
Rate of Interest 8%
Interest Amount 2,20,000
Term Loan = 2,000,000.00
Rate of Interest 11%
Reserves & Surplus Given 2,000,000.00
Total Capital Employed 10,000,000.00

Calculation of Existing ROCE:

EBIT 23,00,000
= = = 23%
Capital EMployed 10,000,000

As per question, the revised ROCE = 23% + 2% = 25%

Alternative 1 - Raising entire amount as term loan from banks @ 12%.

Particulars Amount
Existing Capital Employed 10,000,000.00
Less: Pay off of Debentures (1,000,000.00)
Balance Capital 9,000,000.00
Add: Additional Term Loan 3,000,000.00
Total Capital Employed 12,000,000.00

Particulars Working Amount

Revised EBIT Rs. 12,000,000 X 25% 3,000,000.00
Less: Interest
On Existing Term Loan Rs. 2,000,000 X 11% (220,000.00)
New Term Loan Rs. 3,000,000 X 12% (360,000.00)
EBT 2,420,000.00

By CA Subash Poudel Page 167

 Financial Management
Less: Income Tax @50% (1,210,000.00)
EAT or EAE 1,210,000.00

EAE 1,210,000
Earnings Per Share (EPS) = = = Rs. 2.42 per share
No. of Equity Sahres 5,00,000

Market Price Per Share

P/E Ratio =
EPS

Market Price Per Share

or, 8 =
2.42

Hence, Market Price per Share = Rs. 19.36

Alternative 2 - Raising part of the funds by issue of 1,00,000 shares of Rs 20 each and the rest by term loan
at 12 percent.

Particulars Working Amount

Revised EBIT Rs. 12,000,000 X 25% 3,000,000.00
Less: Interest
On Existing Term Loan Rs. 2,000,000 X 11% (220,000.00)
New Term Loan Rs. 1,000,000 X 12% (120,000.00)
EBT 2,660,000.00
Less: Income Tax @50% (1,330,000.00)
EAT or EAE 1,330,000.00

EAE 1,330,000
Earnings Per Share (EPS) = =
No. of Equity Sahres 5,00,000 (Existing ) + 1,00,000(new)
= Rs. 2.217 per share

Market Price Per Share

P/E Ratio =
EPS

Market Price Per Share

or, 10 =
2.217

Hence, Market Price per Share = Rs. 22.17

i. Advise:
The Primary objective of Financial Management is to maximize the wealth of shareholders. It can be
noted from the above calculations that the market price of Equity Shares is maximized under
Alternative 2. So, alternative 2 should be opted.

ii. If it is assumed that there will be no change in the P/E ratio if either of the two alternatives is adopted,
the market price under alternative 1 would be Rs. 24.20 which is greater than that of Alternative 2. Hence,
Alternative 1 should be opted in that case.

By CA Subash Poudel Page 168