Problem Set 5: Capital Structure

1. Impact of capital structure on profitability & risk

Ross Inc. is an all equity company with value of total assets as well as equity of USD 8000
million. The equity is in the form of 400 million shares outstanding with both book as well as
market value of USD 20 per share. The company is now considering changing its capital structure
using debt to repurchase shares such that under proposed capital structure it will have USD 4000
million of equity consisting of 200 million shares (at USD 20 per share) and USD 4000 million of
debt at interest rate of 10%. Assume that the tax rate is 50%.

The company expects to earn EBIT/Capital of 15% under normal conditions, but 5% under
recession & 25% under expansion. If the scenarios are equally likely, what will be the impact of
the change in capital structure on the expected return on equity (RoE) and earnings per share
(EPS) under different conditions? What does this illustrate about the impact of capital structure on
firm’s performance?

2. Degree of leverage and break-even analysis

a. MS Motors sells 1 million cars. The average price per car is Rs 400,000. Total fixed costs
associated with car production are Rs 100 billion per year. Variable costs per car are Rs
200,000. Interest cost is Rs 60 billion. MS Motors has issued 40 billion shares. Assume a tax
rate of 30%.
i. What will be the impact of 10% decrease in car sales volumes of MS Motors’ EBIT
and EPS?
ii. Find MS Motors’ degree of operating leverage (DOL), degree of financial leverage
(DFL) & degree of combined leverage (DCL).
iii. Find the break-even sales in volume and value terms.
iv. Suppose fixed costs increase from Rs 100 billion to Rs 120 billion, how will DOL,
DFL, DCL change?
v. Suppose interest costs are reduced by Rs 10 billion. How will DOL, DFL, DCL
change?

b. MS Motors decides to sell one of its plants to a contract manufacturer from whom MS Motors
will buy the assembled cars and market them under its own brand name. As a result its sales
will remain the same as earlier, but variable costs will now rise on an average to 250,000 per
car, while fixed costs will decline to Rs 70 billion. Its asset turnover (sales to assets) will
increase to 0.8 with a debt to equity ratio of 2 and interest cost of 12%. Estimate the new
DOL, DFL & DCL.

3. Choice of capital structure based on EPS-EBIT indifference point versus share price impact
Vibgyor Ltd. is considering alternative capital structures for a business.
Plan 1: Equity shares of Rs 1 million
Plan 2: Debentures of Rs 0.5 million with 10% YTM & equity shares of Rs 0.5 million
Plan 3: Equity shares of Rs 0.4 million and preference shares of Rs 0.6 million with dividend
yield of 10.5%.
In all 3 plans the equity shares will be issued at a premium of 150% over face value of Rs 10 per
share that is at Rs 25 per share. Assume tax rate of 30%.

a. Calculate EPS-EBIT indifference point (or break-even EBIT) between each pair of plans.
b. Suppose the expected EBIT next year is Rs 120,000. Which plan will result in maximum
EPS?
 c. Suppose the expected EBIT next year is Rs 120,000. The P/E ratio is likely to be 20 under
plan 1, but 15 under plans 2 & 3. Which plan will result in maximum share price?

4. Capital structure & firm value

Hashtag Inc. is considering alternative capital structures for its new subsidiary. The subsidiary is
expected to earn an EBIT of $120,000 forever on a capital of $500,000 with no growth. Hence it
is expected to return all the profits to its shareholders as dividends with no earnings retention.
Hashtag Inc. is considering 3 capital structure plans:
 Plan 1 (all equity): Equity shares of $500,000 issued at $100 per share. Estimated cost of
equity is 12%.
 Plan 2 (30% debt): Equity shares of $350,000 issued at $100 per share and debt of $150,000.
Estimated cost of equity is 13.50% and of debt is 9.75%.
 Plan 3 (50% debt): Equity shares of $250,000 issued at $100 per share and debt of $250,000.
Estimated cost of equity is 16.00% and of debt is 12.50%.
Assume the tax rate as 50%.

a. Estimate price per share, earnings per share & price earnings ratio.
b. Estimate the market value of equity, debt and firm in each case.
c. Estimate the WACC at market value
d. Determine which capital structure out of the 3 is most optimal?
e. Are the estimates consistent with MM propositions with taxes?

Capital Structure: List of Formulas

change ∈ EBIT Q(P−V ) Contribution

Degree of Operating Leverage, DOL = = =
change ∈sales Q ( P−V ) −F EBIT

change ∈ EPS Q ( P−V )−F EBIT

Degree of Financial Leverage, DFL = = =
change ∈ EBIT Q ( P−V ) −F−I EBT
change ∈ EPS
Degree of Combined Leverage, DCL = = DOL x DFL
change ∈sales
¿ Cost
Break-even Sales Volume =
Contribution per Unit
¿ Cost Contribution
Break-even Sales = where Contribution ratio =
Contribution Ratio Sales
( EBIT −Interest ) × ( 1−t ) −Preference dividend
Earnings per Share, EPS =
No. of Equity Shares

Answers
1. Under existing structure: RoE = 2.5%, 7.5%, 12.5%; EPS = Rs 0.50, Rs 1.50, Rs 2.50
Under new structure: RoE = 0%, 10%, 20%; EPS = 0, Rs 2, Rs 4
2. a i. EBIT declines from Rs 100,000 to Rs 80,000. EPS declines from Rs 0.70 to Rs 0.35
a ii. DOL = 2, DFL = 2.50, DCL = 5
a iii. Break-even sales volume = 0.5 million, Break-even sales value = Rs 200 billion
a iv. DOL = 2.50, DFL = 4, DCL = 10
a v. DOL = 2, DFL = 2, DCL = 4
b. DOL = 1.875, DFL = 2, DCL = 3.75

3. a. Indifference point: Plan 1 & 2 = Rs 100,000, Plan 2 & 3 = Rs 250,000, Plan 1 & 3 = Rs
150,000
b. Plan 2 (EPS = Rs 2.45)
c. Plan 1 (Share price = Rs 42)

4.

100% equity 30% debt 50% debt

EBIT 120,000 120,000 120,000
Interest 0 14,625 31,250
PBT 120,000 105,375 88,750
Tax 60,000 52,687.5 44,375
PAT 60,000 52,687.5 44,375
Dividend 60,000 52,687.5 44,375
N 5000 3500 2500
Book value of equity 500,000 350,000 250,000
Book value of debt 0 150,000 250,000
Book value of firm 500,000 500,000 500,000
DPS 12.00 15.05 17.75
Ke 12% 13.50% 16%
Share price 100 111.48 110.94
EPS 12.00 15.05 17.75
P/E 8.33 7.41 6.25
Mkt value of equity 500,000 390,180 277,350
Kd - 9.75% 12.50%
Market value debt 0 150,000 250,000
Market value of firm 500,000 540,180 527,350
WACC at mkt value 12.00% 11.10% 11.38%

Plan 2 is the most optimal based on cost of capital and market value of firm.