Question 1

To calculate the leverages and degrees of leverage, we’ll use the formulas:

1. Operating Leverage (DOL) = Contribution Margin / Operating Income

2. Financial Leverage (DFL) = Operating Income / Net Income

3. Combined Leverage (DCL) = Operating Leverage * Financial Leverage

Question 2

Let’s calculate the leverages and degrees of leverage for the given scenarios:

Scenario 1:

Sales: $120 million

Variable Cost: $70 million

Fixed Cost: $30 million

1. Operating Leverage (DOL):

Contribution Margin = Sales – Variable Cost = $120 million - $70 million = $50 million

Operating Income = Contribution Margin – Fixed Cost = $50 million - $30 million = $20 million

DOL = Contribution Margin / Operating Income = $50 million / $20 million = 2.5

2. Financial Leverage (DFL):

Net Income = Operating Income = $20 million

DFL = Operating Income / Net Income = $20 million / $20 million = 1

3. Combined Leverage (DCL):

DCL = Operating Leverage * Financial Leverage = 2.5 * 1 = 2.5

Question 3

Scenario 2:

Sales: $200 million

Variable Cost: $80 million

Fixed Cost: $90 million

1. Operating Leverage (DOL):

Contribution Margin = Sales – Variable Cost = $200 million - $80 million = $120 million

Operating Income = Contribution Margin – Fixed Cost = $120 million - $90 million = $30 million

DOL = Contribution Margin / Operating Income = $120 million / $30 million =

Question 4

2. Financial Leverage (DFL):

Net Income = Operating Income – Interest on borrowed funds = $30 million - $0 = $30 million

DFL = Operating Income / Net Income = $30 million / $30 million = 1

3. Combined Leverage (DCL):

DCL = Operating Leverage * Financial Leverage = 4 * 1 = 4

Question 5

Now let’s calculate the leverages and degrees of leverage for the firms A, B, and C:

Firm A:

1. Output (Units): 60,000

2. Fixed Costs: $7,000

3. Variable Costs per unit: $0.22

4. Interest on borrowed funds: $4,000

5. Selling price per unit (Rs.): $0.60

1. Operating Leverage (DOL):

Contribution Margin = Selling price per unit – Variable Costs per unit = $0.60 - $0.22 = $0.38

Operating Income = Contribution Margin * Output – Fixed Costs = $0.38 * 60,000 - $7,000 = $13,300

DOL = Contribution Margin / Operating Income = $0.38 / $13,300 = 0.0286

2. Financial Leverage (DFL):

Net Income = Operating Income – Interest on borrowed funds = $13,300 - $4,000 = $9,300

DFL = Operating Income / Net Income = $13,300 / $9,300 = 1.4301

3. Combined Leverage (DCL):

DCL = Operating Leverage * Financial Leverage = 0.0286 * 1.4301 = 0.041

Firm B:

1. Output (Units): 15,000

2. Fixed Costs: $14,000

3. Variable Costs per unit: $1.50

4. Interest on borrowed funds: $8,000

5. Selling price per unit (Rs.): $5.00

1. Operating Leverage (DOL):

Contribution Margin = Selling price per unit – Variable Costs per unit = $5.00 - $1.50 = $3.50

Operating Income = Contribution Margin * Output – Fixed Costs = $3.50 * 15,000 - $14,000 = -$1,500

DOL = Contribution Margin / Operating Income = $3.50 / -$1,500 = -0.0023

 2. Financial Leverage (DFL):

Net Income = Operating Income – Interest on borrowed funds = -$1,500 - $8,000 = -$9,500

DFL = Operating Income / Net Income = -$1,500 / -$9,500 = 0.1579

3. Combined Leverage (DCL):

DCL = Operating Leverage * Financial Leverage = -0.0023 * 0.1579 = -0.0004

Firm C:

1. Output (Units): 100,000

2. Fixed Costs: $1,500

3. Variable Costs per unit: $0.02

4. Interest on borrowed funds: Not provided

5. Selling price per unit (Rs.): $0.10

Question 6
To solve the given problems, I will use various financial leverage and capital structure formulas.
Let’s go through each problem one by one.

Problem 1:
Sales: $120,000
Variable Cost: $75,000
Fixed Cost: $25,000
Long-term loans at 10%: $40,000

a) Degree of Operating Leverage (DOL):

DOL = Contribution Margin / Operating Income
Contribution Margin = Sales – Variable Cost = $120,000 - $75,000 = $45,000
Operating Income = Sales – Variable Cost – Fixed Cost = $120,000 - $75,000 - $25,000 = $20,000

DOL = $45,000 / $20,000 = 2.25

b) Degree of Financial Leverage (DFL):
DFL = EBIT / (EBIT – Interest Expense)
EBIT = Sales – Variable Cost – Fixed Cost = $120,000 - $75,000 - $25,000 = $20,000
Interest Expense = Long-term loans * Interest Rate = $40,000 * 0.10 = $4,000

DFL = $20,000 / ($20,000 - $4,000) = 1.25

c) Combined Leverage:
Combined Leverage = DOL * DFL = 2.25 * 1.25 = 2.8125

Question 7
Problem 2:
Northwestern Savings and Loan:
Debt: $250,000 (16% interest rate)
Common Stock: 2,000 shares
Tax rate: 40%

a) Earnings per Share (EPS) for EBIT = $80,000:

Interest Expense = Debt * Interest Rate = $250,000 * 0.16 = $40,000
EBT = EBIT – Interest Expense = $80,000 - $40,000 = $40,000
Taxes = EBT * Tax Rate = $40,000 * 0.40 = $16,000
Net Income = EBT – Taxes = $40,000 - $16,000 = $24,000
EPS = Net Income / Number of Shares = $24,000 / 2,000 = $12

b) Degree of Financial Leverage (DFL) for EBIT = $80,000:

DFL = (% change in EPS) / (% change in EBIT)
% change in EPS = (EPS for EBIT = $120,000 – EPS for EBIT = $80,000) / EPS for EBIT = $80,000
% change in EBIT = (EBIT = $120,000 – EBIT = $80,000) / EBIT = $80,000

DFL = ($12 - $12) / $12 = 0

The degree of financial leverage (DFL) is 0, indicating that the change in EBIT does not affect EPS.

Problem 3:
Firm’s Sales: $1,000,000
Variable Cost: $700,000
Fixed Cost: $200,000
Debt: $500,000 (10% interest rate)

a) Operating Leverage:
Operating Leverage = Contribution Margin / Operating Income
Contribution Margin = Sales – Variable Cost = $1,000,000 - $700,000 = $300,000
Operating Income = Sales – Variable Cost – Fixed Cost = $1,000,000 - $700,000 - $200,000 =
$100,000
Operating Leverage = $300,000 / $100,000 = 3

b) Financial Leverage:
Financial Leverage = Debt / Equity
Debt = $500,000
Equity = 0 (not provided)

c) Combined Leverage:
Combined Leverage = Operating Leverage * Financial Leverage

Question 9
Problem 4:
Hawaiian Macadamia Nut Company:

Debt (%) | Kd (Cost of Debt) | Ke (Cost of Equity)

0 | 10% | 15
10 | 10% | 15
20 | 12% | 16
30 | 13% | 17
40 | 15% | 19
50 | 16% | 20
60 | 18% | 22

Question 10
To calculate the value of the firm and the overall capitalization rate using the Net Income
Approach, we can use the following formula:

Value of the Firm = Net Income / Capitalization Rate

Overall Capitalization Rate = Net Income / Value of the Firm

Given:
Net Income = $1,000,000
Equity Capitalization Rate = 11%

Let's calculate the value of the firm first:

Value of the Firm = $1,000,000 / 0.11

Value of the Firm = $9,090,909.09

Now, let's calculate the overall capitalization rate:

Overall Capitalization Rate = $1,000,000 / $9,090,909.09

Overall Capitalization Rate = 0.11

So, the value of the firm is approximately $9,090,909.09, and the overall capitalization rate is
11%Question 11.
To calculate the new value of the firm and the overall capitalization rate when the debenture
debt is increased to $2,000,000, we need to consider the interest expense associated with the
increased debt.

Given:
Debenture debt (initial) = $600,000
Debenture debt (increased) = $2,000,000
Interest rate = 12%

To calculate the new value of the firm, we subtract the interest expense associated with the
increased debt from the net operating income (NOI) and divide it by the overall capitalization
rate.

Interest expense (initial) = Debenture debt (initial) * Interest rate = $600,000 * 12% = $72,000
Interest expense (increased) = Debenture debt (increased) * Interest rate = $2,000,000 * 12% =
$240,000

Net Operating Income = Net Operating Income – Interest expense (initial) + Interest expense
(increased)
Net Operating Income = $200,000 - $72,000 + $240,000 = $368,000

Calculating the new value of the firm:

Value of the Firm = Net Operating Income / Overall Capitalization Rate

Value of the Firm = $368,000 / 20% = $1,840,000

Therefore, when the debenture debt is increased to $2,000,000, the value of the firm would be
$1,840,000.

To calculate the new overall capitalization rate, we divide the net operating income by the new
value of the firm.

Overall Capitalization Rate = Net Operating Income / Value of the Firm

Overall Capitalization Rate = $368,000 / $1,840,000 = 20%

Hence, the overall capitalization rate remains the same at 20% when the debenture debt is
increased to $2,000,000.
Question 12
To calculate the value of the firm and the equity capitalization rate using the Net Operating
Income (NOI) approach, we can use the following formulas:
Value of the Firm = Net Operating Income / Overall Capitalization Rate

Equity Capitalization Rate = Net Operating Income / Value of the Firm

Given:
Net Operating Income = $200,000
Debenture lending (initial) = $600,000
Interest rate on debenture = 12%
Overall Capitalization Rate = 20%

Calculating the value of the firm:

Value of the Firm = $200,000 / 20% = $1,000,000

Calculating the equity capitalization rate:

Equity Capitalization Rate = $200,000 / $1,000,000 = 20%

Question 13

Now, let’s calculate the impact on the value of the firm and equity capitalization rate if the
debenture amount is increased to $750,000.

Given:
Debenture lending (increased) = $750,000

To calculate the new value of the firm and equity capitalization rate, we need to consider the
interest expense associated with the increased debenture amount.

Interest expense (initial) = Debenture lending (initial) * Interest rate = $600,000 * 12% = $72,000

Interest expense (increased) = Debenture lending (increased) * Interest rate = $750,000 * 12% =
$90,000

Net Operating Income = Net Operating Income – Interest expense (initial) + Interest expense
(increased)
Net Operating Income = $200,000 - $72,000 + $90,000 = $218,000

Calculating the new value of the firm:

Value of the Firm = $218,000 / 20% = $1,090,000

Calculating the new equity capitalization rate:

Equity Capitalization Rate = $218,000 / $1,090,000 = 20%

Therefore, when the debenture amount is increased to $750,000, the value of the firm would be
$1,090,000, and the equity capitalization rate would remain the same at 20%.

Moving on to the second part of your question regarding companies ALtd., ZLtd., and MLtd.

Given:
EBIT (Earnings Before Interest and Taxes) = $200,000
Debt of ALtd. = $1,000,000 at 8% rate of interest
Cost of equity of ZLtd. = 11%
Cost of equity of MLtd. = 12%

To carry out the arbitrage process, we need to compare the cost of equity with the rate of return
on investment.
Question 14
1. ALtd.:
The cost of equity for ALtd. Is not provided in the question, so we cannot directly compare it
with the cost of equity for ZLtd. Or MLtd. Without the cost of equity for ALtd., we cannot
determine the arbitrage opportunities.

2. ZLtd. And MLtd.:

The cost of equity for ZLtd. Is 11%, and for MLtd., it is 12%. Since ZLtd. Has a lower cost of equity
compared to MLtd., it is considered a more attractive investment in terms of the cost of equity.

Arbitrage involves taking advantage of price discrepancies between two securities or markets. In
this case, if an investor has the ability to invest in both ZLtd. And MLtd., they would likely choose
to invest in ZLtd. Due to its lower cost of equity. This decision is based on the assumption that
the risk profile and profitability of ZLtd. And MLtd. Are similar.

By investing in ZLtd., the investor aims to capture the potential difference in returns between the
two companies and generate arbitrage profits.

Lastly, you mentioned two alternative methods of financing for a firm with an all-equity capital
structure:

1. To issue 2,500 ordinary shares at $100 each.

2. To borrow $250,000 at an 8% rate of interest.

The choice between the two options depends on several factors such as the firm’s capital
structure preferences, cost of capital, risk tolerance, and impact on shareholder value. The firm
needs to evaluate the advantages and disadvantages of each option in terms of ownership
dilution, interest expense, debt obligations, and potential impact on shareholder return. The
final decision will depend on the specific circumstances and goals of the firm.
Question 15
To determine the effect on earnings per share (EPS) under the two financing alternatives, we
need to calculate the earnings available to ordinary shareholders in each case.

1. Financing Alternative 1: Issuing 2,500 ordinary shares at ₹100 each:

Under this alternative, the firm will raise ₹2,50,000 by issuing 2,500 new shares at ₹100 per
share.

Earnings available to ordinary shareholders:

Earnings before interest and taxes (EBIT) = ₹3,12,500
Tax rate = 50%

Tax expense = EBIT * Tax rate

Tax expense = ₹3,12,500 * 0.5 = ₹1,56,250

Earnings available to ordinary shareholders = EBIT – Tax expense

Earnings available to ordinary shareholders = ₹3,12,500 - ₹1,56,250 = ₹1,56,250

Number of ordinary shares after issuing new shares = 10,000 + 2,500 = 12,500 shares

Earnings per share (EPS) = Earnings available to ordinary shareholders / Number of ordinary
shares
EPS = ₹1,56,250 / 12,500 = ₹12.50 per share

2. Financing Alternative 2: Borrowing ₹2,50,000 at an 8% rate of interest:

Under this alternative, the firm will borrow ₹2,50,000 at an 8% rate of interest.

Interest expense = Borrowed amount * Interest rate

Interest expense = ₹2,50,000 * 0.08 = ₹20,000

Earnings available to ordinary shareholders = EBIT – Tax expense – Interest expense

Earnings available to ordinary shareholders = ₹3,12,500 - ₹1,56,250 - ₹20,000 = ₹1,36,250

Number of ordinary shares remains the same at 10,000 shares.

EPS = Earnings available to ordinary shareholders / Number of ordinary shares

EPS = ₹1,36,250 / 10,000 = ₹13.625 per share

Therefore, under the two financing alternatives, the effect on earnings per share (EPS) would be:
- Financing Alternative 1: Issuing new shares at ₹100 each would result in an EPS of ₹12.50 per
share.
- Financing Alternative 2: Borrowing ₹2,50,000 at an 8% rate of interest would result in an EPS of
₹13.625 per share.
Chapter Two
1.To calculate the impact on the market price of the share under various dividend policies and
determine the price per share using Walter's Model, Modigliani and Miller's (MM) approach,
and Gordon's Model, I will address each question separately.

1. Impact on Market Price of Share using Walter's Model:

Given:
- Earnings per share (EPS) = $50
- Capitalization rate = 10%
- Rate of return generated by the firm = 12%

a) 0% Payout:
Under this dividend policy, the entire earnings are retained by the company and not distributed
as dividends. According to Walter's Model, the market price of the share can be calculated as
follows:

Price per share = (EPS / Ke)

Price per share = ($50 / 0.12)
Price per share = $416.67

b) 100% Payout:
Under this dividend policy, the company distributes all its earnings as dividends. According to
Walter's Model, the market price of the share can be calculated as follows:

Price per share = (EPS - D) / (Ke - g)

Price per share = ($50 - $50) / (0.12 - 0)
Price per share = $0 / 0.12
Price per share = $0

Question 2. Market Price of the Share using MM Model:

Given:
- Earnings per share (EPS) = $10
- Capitalization rate = 12%
- Return on retained earnings (g) = 15%, 10%, 5%

a) 50% Dividend Payout:

According to MM Model, the market price of the share when the company pays a dividend can
be calculated as follows:

Price per share = (EPS × (1 - Payout ratio)) / (Ke - g)

Price per share = ($10 × (1 - 0.5)) / (0.12 - 0.15)
Price per share = $5 / (-0.03)
Price per share = -$166.67 (negative value indicates an unrealistic scenario)

b) 75% Dividend Payout:

Price per share = ($10 × (1 - 0.75)) / (0.12 - 0.10)
Price per share = $2.50 / 0.02
Price per share = $125

c) 100% Dividend Payout:

Price per share = ($10 × (1 - 1)) / (0.12 - 0.05)
Price per share = $0 / 0.07
Price per share = $0

Question .7
. Market Price of the Share using Gordon's Model:

Given:
- Net profit = $30,000
- Number of common shares = 1,000
- Par value per share = $100
- Return on investment (Ke) = 15%
- Cost of capital (Ke) = 14%
- Dividend payout ratio = 25%, 50%, 100%

a) 25% Dividend Payout:

According to Gordon's Model, the market price per share can be calculated as follows:

Price per share = (Net profit × (1 - Dividend payout ratio)) / (Ke - g)

Price per share = ($30,000 × (1 - 0.25)) / (0.14 - 0.15)
Price per share = $22,500 / (-0.01)
Price per share = -$2,250,000 (negative value indicates an unrealistic scenario)

b) 50% Dividend Payout:

Price per share = ($30,000 × (1 - 0.5)) / (0.14 - 0.15)
Price per share = $15,000 / (-0.01)
Price per share = -$1,500,000 (negative value indicates an unrealistic scenario)

c) 100% Dividend Payout:

Price per share = ($30,000 × (1 - 1)) / (0.14 - 0.15)
Price per share = $0 / 0.01
Price per share = $0