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CAPITAL STRUCTURE THEORIES

Problem No. 1 (Net Income Approach)

A company’s expected annual net operating income (EBIT) is Rs.50000. The company has Rs.200000, 10%
Debentures. The equity capitalization rate (Ke) of the company is 12.5%

1. Calculate value of firm and WACC as per NI approach


2. Suppose that the firm has decided to raise the amount of debentures by Rs.100000 and use the
proceeds to retire the equity shares. Calculate value of firm and WACC.
3. Suppose that the amount of debt has been reduced by Rs.100000 and a fresh issue of equity shares is
made to retire the debentures. Calculate value of firm and WACC.

Problem No. 2 (Net Operating Income Approach)

A company’s expected annual net operating income (EBIT) is Rs.50000. The company has Rs.200000, 10%
Debentures. The overall capitalization rate (Ko) of the company is 12.5%

1. Calculate value of firm and Ke as per NOI approach


2. Suppose that the firm has decided to raise the amount of debentures by Rs.100000 and use the
proceeds to retire the equity shares. Calculate value of firm and Ke.
3. Suppose that the amount of debt has been reduced by Rs.100000 and a fresh issue of equity shares is
made to retire the debentures. Calculate value of firm and Ke.

Problem No. 3 (MM Theory)

Assume there are two firms, L and U, which are identical in all respect except that firm L has 10%, Rs.500000
debentures. The EBIT of both the firms are equal, that is, RS.100000. The equity capitalization rate of firm L is
16% and that of firm U is 12.5%.

1. Calculate the overall capitalization rate and value of firm.


2. Suppose an investor, Mr. X is holding 10% of the outstanding shares of the levered firm L. Show the
arbitrage process.
3. Assume that the equity capitalization rate is 20% in the case of the levered firm L. Show the arbitrage
process.

Problem No. 4 (Traditional Approach)

Assume a firm has EBIT of Rs.40000. The firm has 10% debentures of Rs.100000 and its equity capitalization
rate is 16%.

1. Calculate value of firm and its overall capitalization rate.


2. The firm is considering increase its leverage by issuing additional Rs.50000 debentures and using the
proceeds to retire that amount of equity. However, as the firm increase the proportion of debt, Ki would
rise to 11% and Ke to 17%. Calculate value of firm and Ko.
3. The firm is considering increase its leverage by issuing additional Rs.100000 debentures and using the
proceeds to retire that amount of equity. However, as the firm increases the proportion of debt, Ki
would rise to 12.5% and Ke to 20%. Calculate value of firm and Ko.
Problem No. 5

Assume no taxes and given the EBIT, interest at 10% and equity capitalization rate below, calculate the total
market value of each firm.
Firms EBIT Interest Ke
X 200000 20000 12
Y 300000 60000 16
Z 500000 200000 15
W 600000 240000 18
Also determine the WACC for each firm.

Problem No. 6

A company’s current operating income is Rs.4 lakh. The firm has Rs.10 lakh of 10% debt outstanding. Its cost of
equity capital is estimated to be 15%.
(a) Determine the current value of the firm as per traditional approach.
(b) Calculate the overall capitalization rate as well as both type of leverage ratio: (a) B/S (b) B/V.
(c) The firm is considering increasing its leverage by raising an additional Rs.500000 debt and using the
proceeds to retire that amount of equity. As a result of increase financial risk Ki is likely to go up to 12%
and Ke to 18%. Would you recommend the plan?

Problem No. 7

Co. X and Co. Y are identical in all respect including risk factor except for debt equity proportion, Co. X have an
issued 10% debentures of Rs.9 lacs while company Y has issued only equity. Both company earned 20% before
interest and taxes on total assets of Rs.15 lacs. Assume a tax rate of 35% and capitalization rate of 15% for all
equity company.
1. Compute the value of Company X and Company Y using;
(i) Net income approach
(ii) NOI approach
2. Using the NOI approach, calculate the overall cost of capital for firm X and Y.
3. Which of the firm has an optimal capital structure? Why?

Problem No. 8

In considering the most desirable capital structure of a company, the following estimates of the cost of debt and
equity capital have been made at various levels of debt equity mix:
You are require to determine optimum debt equity mix for the company by calculating the Cost of Capital

Debt as % of total capital Cost of debt Cost of equity


0 5 12
10 5 12
20 5 12.5
30 5 13
40 6 14
50 6.5 16
60 7 20

Problem No. 9

The two companies, U and L, belong to an equivalent risk class. These two firms are identical in every respect
except that U company is unlevered while company L has 10% debentures of Rs.30 lakhs. The relevant
information regarding their valuation and capitalization rates are as follows:
Particulars Firm U Firm L
Net operating income (EBIT) 750000 750000
Interest on debt (I) Nil 300000
Earning to equity holders (NI) 750000 450000
Equity capitalization rate (Ke) 0.15 0.20
Market value of equity (S) 5000000 2250000
Market value of debt (B) Nil 3000000
Total value of firm (V=S+B) 5000000 5250000
Implied overall capitalization (Ko) 0.15 0.143
Debt-equity (B/S) 0 1.33
(a) An investor owns 10% equity shares of company L. show the arbitrage process and the amount by
which he could reduce his outlay through the use of leverage.
(b) According to MM, when will this arbitrage proceeds come to an end?

Problem No.10:
The two companies X and Y belons to same risk class. They have everthing in common except that firm Y has
10% Debentures of Rs.5 lakh. The valuation of the two firm is assumed to be as follow:
Particulars Firm U Firm L
Net operating income (EBIT) 750000 750000
Interest on debt (I) Nil 50000
Earning to equity holders (NI) 750000 700000
Equity capitalization rate (Ke) 0.125 0.14
Market value of equity (S) 6000000 5000000
Market value of debt (B) Nil 500000
Total value of firm (V=S+B) 6000000 5500000
Implied overall capitalization (Ko) 0.125 0.1363
Debt-equity (B/S) 0 0.10
An investor owns 10% of the equity share of the overvalued firm. Determine his investment cost of earnings the
same income so that he is at BEP? Will he gain by investing in the undervalued firm?

Problem No. 11:


The following information is of two companies X nad Y belonging to the same risk class:
Particulars X Y
Number of ordinary shares 90000 150000
Market price per share Rs.1.20 Rs.1.00
6% debentures 60000 Nil
Profit before interest 18000 18000
All profits after debentures interest are distributed as dividends.
Explain how under MM approach an investor holding 10% of shares in company X will be better off in switch
holding to company Y.