GIM- FM II Mid Term (Weight 30%) Total Marks = 40

Duration: 1 Hour 15 Minutes

Instructions:
1. This is a closed book exam. Only calculators are allowed.
2. There are 3 questions. Q.1 carries 10 marks, Q.2 10 marks and Q.3 20 marks. Assign your
time on each question accordingly.
3. Write your answers in the space provided in the question paper and return the same.
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Q. 1
(a) Draw the Trade-off theory diagram, indicate the variables on x-axis and y-axis, and show the
relevant sections that demonstrate trade-offs. (6 Marks)

1
(b) State M&M Propositions under corporate taxes. (2 Marks)

Proposition I Value of the levered firm is higher than that of unlevered firm. 1 mark
Proposition II The weighted average cost of capital (WACC) falls as debt is added. 1 mark

(c) Name four sources of debt financing. (2 Marks)

Bank loans/term loans 0.5 mark
Bonds/debentures 0.5 mark
Lease finance 0.5 mark
Preference/non-redeemable preference shares 0.5 mark

Q.2: The financial data of current operations and the proposed expansion for a company are as
follows: (10 marks)

Particulars Current operations Proposed expansion

Total investment 200 mn of which debt 50 mn @ 100 mn of which debt 50 mn @
8% interest 8% interest
Operating revenue 220 mn 100 mn
Variable costs 50% of operating revenue 50% of operating revenue
Fixed costs 60 mn 30 mn

Based on the above data, fill in the following Table – Assume income tax rate of 30%.

EBIT after expansion in million 70 mn 2 marks

EBT after expansion in million 62 mn 2 marks

Degree of operating leverage after 2.29/2.286 3 marks

expansion
Degree of financial leverage after 1.13 3 marks
expansion

Q.3 Alpha Ltd. (AL) was an asset-intensive company producing decorative building materials. After
initial public offering (IPO), it used internal accruals as source of funds to the extent possible and then
relied on both short-term and long-term borrowings from a commercial bank to sustain growth. The
current interest rate on these borrowings was 12% per annum. The effective income tax rate was 30%.
The current capital included 5 million shares of face value of 1. The family held 60% of total shares and
other investors held the rest. The average market value of shares during the last quarter of 2021-22
was around 36 per share.

2
The latest financial data for the year ended on 31/3/2022, key debt ratios for 2021-22, and the
projections for the year 2022-23 are given in the following Table:

Particulars Rs. In Million

Actual Forecast
Assets 31-3-2022 31-3-2023

Cash 2 3
Accounts Receivable 15 18
Inventories 13 14
Total Current Assets 30 35
Net Property & Equipment 27 25
Total Assets 57 60

Liabilities & Owners' Equity

Short-term borrowings 15 17
Accounts Payable 5 2
Total Current Liabilities 20 19
Long-Term Debt 22 24
Total Outside Liabilities 42 43
Share Capital including premium, if any 5 5
Retained earnings 10 12
Total Shareholder Equity 15 17
Total Liabilities & Owners’ Equity 57 60

Debt ratios:
Equity multiplier (Assets/equity=FL) 3.8 3.53
Interest-bearing debt ÷ total assets 64.91% 68.83
Short term borrowings ÷ total current 50% 48.57%
assets
Current holding of the family 60% 60%

Both the management and the bank officials were concerned about the current financial position of
the company in terms of leverage, debt: equity ratio, and total debt in relation to total assets. In
consultation with the bank officials, the management decided to raise an additional equity of 12
million by 31st March 2022. In late February 2022, the management explored various options of raising
the equity. A HNI investor was interested to invest in this company. This would require issuance of
400,000 shares having face value of 1 @ net price of 30 per share. It was agreed that the entire equity
proceeds would be used only to repay the short-term borrowings. Any reduction in interest due to
repayment would also be used to repay the short-term borrowings. Such repayments would be made
on 1st April, 2022.

3
Compute the impact of the proposed equity issue on the forecast for 2022-23 and state them in the
following table: (20 Marks)

Particulars Your answer (2022-23) Marks

Savings in interest due to repayment of short-term 0.84 mn 4
borrowings (hint: consider impact of income tax)
Total repayment of short-term borrowings 12.84 mn 4
Share Capital including premium, if any as on 31-3- 17 mn 2
2023
Retained earnings as on 31-3-2023 12.84 2
% holding of the family 55.56% 2
Debt ratios:
Equity multiplier (Assets/equity=FL) 2.01 2
Interest-bearing debt in relation to total assets 46.93% 2
Short term borrowings in relation to total current 11.89% 2
assets

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