Pondicherry University

Department of Management Studies

Financial Management
Test IV
Capital Structure, Leverage and Dividend

1) i) PPP ltd expects an operating income of Rs.80 lakhs. It has 2 crores of 8% debentures. The
equity capitalisation rate is 10%. You are required to calculate 1) Value of the firm and 2)
Overall capitalisation rate according to the Net Income approach. 3) if the debenture debt is
increased to 3 crores what shall be the value of the firm and overall capitalisation rate?

1)ii)The company has an operating income (EBIT) of Rs.2 crores. The cost of debt is 10% and
an outstanding debt amounting to Rs.8 crores. The overall capitalisation rate is 12.5%. The
company decides to increase the amount of debt from Rs 8 crores to Rs.10 crores at 10% and
uses the proceeds to pay-off the equity shareholders. You are required to calculate the total
value of the firm and also the equity capitalisation rate according to the NOI approach

2)i) A company has 10,000 shares of Rs.100 each, selling at Rs.120 each. It has also 10%
Rs.12,00,000 debt. The operating profit is Rs.2,40,000. The required rate of return on equity is
20%. Find out WACC under MM approach assuming a) no tax b) tax rate 30%.

2)ii) Blue Sky Limited has an EBIT Rs.2, 00,000. The cost of debt is 10% and the outstanding
debt is Rs.9, 00,000. The overall capitalization rate is 12.5%. Calculate the total value of the
firm and equity capitalization rate.

3)i) A company has a capital of Rs.5,00,000 with an equity capitalisation rate of 15% with no
taxes. The finance manager likes to introduce financial leverage for which he has the following
information. Find out the optimal capital structure.
Debt Interest rate % Ke
- 15.0
1,00,000 8.0 15.5
2,00,000 8.0 16.0
3,00,000 9.0 17.5
4,00,000 9.0 18.5
5,00,000 9.5 19.0

3)ii) Following information are given below table. Find out the optimum capital structure.
Debt as % of total capital employed Cost of debt (%) Cost of Equity
0 5 12
10 5 12
20 5 12.5
30 5.5 13
40 6 14
 50 6.5 16
60 7 20

4) A company has a capital of Rs.10,00,000 with an equity capitalisation rate of 14% with no
taxes. The finance manager likes to introduce financial leverage for which he has the following
information
Debt Interest rate % Ke
- - 14.0
1,00,000 8.0 15.0
2,00,000 8.0 16.0
3,00,000 9.0 17.0
4,00,000 9.0 17.5
5,00,000 9.5 18.0
6,00,000 10.5 24.0
Find a) equity capitalisation rate based on MM approach and b) the amount of debt that denotes
the optimal capital structure

5) Ramco company is considering three financial plans. The key information is as follows
Total investment to be raised is 4 million. The management wishes to raise issue of 2,00,000
shares @ Rs.20 or issue of bonds at 10% interest or 50% from each source. Corporation tax
rate is assumed to be 45%. Company’s projected EBIT amounted to Rs.6.5 million. The
existing capital structure company is Rs.2 million in bonds at 8% interest and 1,00,000 share
of stock. You are required to determine for each plan a) EPS b) Point of Indifference c)
Financial break-even point.

6) ABC ltd is considering three financial plans. The key information is as follows
a) Total investment to be raised is Rs.2,00,000
b) Plans of financing proportion
Plan Equity Debt Preference
A 100% - -
B 50% 50% -
C 50% - 50%
c) Cost of debt is 8%, Cost of Preference shares is 8%
d) Tax rate 50%
e) Equity shares of face value of Rs.10 each will be issued at a premium of Rs.10 per share
f) Expected EBIT is Rs.80,000
You are required to determine EPS, The financial break-even point, EBIT range among the
plans of indifference.
7) i) Alpha Company Limited has an all-equity capital structure consisting of 20,000 equity
shares of Rs.100 each. The management plans to raise Rs.30 lakhs to finance a programme
of expansion. Three alternative methods of financing are under consideration.
i) Issue of 30,000 new shares of Rs.100 each
ii) Issue of 30,000 8% debentures of Rs.100 each
iii) Issue of 30,000 8% preference shares of 100 each
The company’s expected earnings before interest and taxes (EBIT) are Rs.10 lakhs. Determine
the earnings per share in each alternative assuming a corporate tax rate of 50 per cent. Which
alternative is best and why?

7) ii) A new project under consideration requires a capital outlay of Rs. 300 lacs 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 lacs and by the issue of 15% loan of Rs. 100 lacs. Find out the
indifference level of EBIT given the tax rate at 50%.

8) A firm’s details are as under

Sales (@100 per unit) Rs. 24,00,000
Variable cost 50%
Fixed cost Rs. 10,00,000
It has borrowed Rs. 10,00,000 @ 10% p.a and its equity share capital is Rs.10,00,000 (Rs.
100 each)
Calculate operating leverage, financial leverage, Combined leverage, ROI. If the sales
increases by Rs. 6,00,000 what will be the new EBIT?

9) Calculate the operating leverage, financial leverage and combined leverage from the
following data under situation I and II and Financial Plan A and B
Installed Capacity 4,000 units
Actual Production and Sales 75% of the capacity
Selling Price Rs.30 per unit
Variable cost Rs.15 per unit
Fixed cost
Under Situation I Rs.15,000
Under Situation II Rs.20,000

Financial plan A Rs. Plan B Rs.

Equity 10,000 15,000
Debt (Rate of Interest at 20%) 10,000 5,000
20,000 20,000

10) i) A firm has a sale of Rs.3,00,000. The cost of goods amounts to 60% of the sale. The
operating cost is further 10% of the sale value. Find the operating leverage. How much does
the operating cost need to be reduced to get a DOL of 1.2, with a given contribution margin of
Rs.1,20,000.
10)ii) The capital structure of William Corporation ltd. Consists of an ordinary share capital of
Rs.20 lakhs (shares of Rs100 per value) and Rs. 20 lakhs of 10% debentures. The unit sales
increased by 20% from 2,00,000 units to 2,40,000 units, the selling price is Rs.10 per unit,
variable cost amounts to Rs. 6 per unit and fixed expenses amount to Rs.3,00,000. The income
tax is assumed to be 50%. You are required to calculate a) percentage of increase in EPS b) The
degree of financial leverage at 2,00,000 units and 2,40,000 units 3) The degree of operating
leverage at 2,00,000 units and 2,40,000 units.

11)i)From the given information you are required to calculate a) degree of operating leverage
b) Degree of financial leverage c) Degree of combined leverage
Particulars X Y Z
Output (in units) 30,00,000 7,50,000 50,00,000
Fixed costs 35,00,000 70,00,000 7,50,000
Variable cost per unit 1.00 7.50 0.10
Interest expenses 2,50,000 4,00,000 -
Selling price per unit 3 25 0.50

11) ii)The following summarises the percentage changes in operating income, percentage
changes in revenues and betas for the four pharmaceuticals firms
Firm Change in Revenue Change in Operating Beta
Income
PQR 27% 25% 1.00
RST 25% 32% 1.15
TUV 23% 36% 1.30
WXY 21% 40% 1.40

You are required to

a) Calculate the degree of operating leverage for each of these firms. Also comment
b) Use the operating leverage to explain why these firms have different beta?

12)i)The following figures relates to two companies: (rupees in lakhs)

P LTD Q LTD
Sales 500 1000
Variable cost 200 300
Contribution margin 300 700
Fixed cost 150 400
Earnings before interest and tax 150 300
Interest 50 100
Profit before tax 100 200
You are required to:
a) Calculate the operating, financial and combined leverages for both the companies.
b) Comment on the relative risk position of these companies.
12)ii) Consider the following information for Alpha Limited:
Rs. In lakh
EBIT 1,120
PBT 320
Fixed cost 700
Calculate:
i)The degree of operating leverage
ii)The degree of financial leverage
iii)The degree of combined leverage
iv)The percentage change in earnings per share if sales increase by 5 percent

13) i) A company has operating profit of Rs.10,00,000. The capital structure is all equity with
1,00,000 shares outstanding. The tax rate is 30%. The company has a viable project in hand
that costs Rs.6,00,000. Based on the residual theory of dividend, find out the EPS and dividend
per share.

13) ii) The cost of equity capital is 15%. MPS is Rs.60. Based on Walter’s theory of dividend,
find out the MPS if EPS is Rs.12 and the dividend pay-out ratio is 40%.

14)i) A company has EBIT of Rs.4,00,000, tax rate 30%, dividend pay- out ratio 40%, No. of
outstanding shares is 1,00,000, equity capitalisation rate is 15% and ROI is 12%, Find the MPS
based on Gordon’s theory of dividend.

14)ii)The following information is given for QB ltd.

Earnings per share ₹12
Dividend per share ₹3
Cost of capital 18%
Internal rate of return on investment 22%
Retention ratio 40%
Calculate the market price per share using:
i) Gordon’s formula
ii) Walters formula

15) i)A firm has had the following earnings per share over the last three years:
Year EPS
2009 1.00
2010 2.00
2011 3.00
(a) If the firm's dividend policy was based on a constant payout ratio of 50 percent,
determine the annual dividend for each year.
 (b) If the firm's divided policy was based on a fixed rupee payout policy of 50 paise per
share plus an extra dividend equal to 75 percent of earnings per share above 1.00,
determine the annual dividend for each year.

15)ii) A company has the following figures of EPS during past five years
Year EPS
2000 1.80
2001 2.00
2002 2.2
2003 1.7
2004 3.00

Determine the annual dividend per share under the following conditions
a) Stable dividend pay-out ratio of 50%
b) A regular dividend of Rs.1 and extra dividend to match with the stable dividend pay-
out ratio

16) XYZ Ltd has a capital of Rs. 10, 00,000 in equity shares of Rs. 100 each. The shares are
currently quoted at par. The company proposes to declare a dividend of Rs, 10 per share at
the end of the current financial year. The capitalization rate for the risk class to which the
company belongs is 12%. What will be the market price of the share at the end of the year, if
(i) A dividend is not declared?
(ii) A dividend is declared?
Assuming that the company pays the dividend and has net profit of Rs. 5, 00,000 and makes
new investments of Rs. 10,00,000 during the period, how many new shares must be issued?
Use Modigliani and Miller approach.