THEORIES OF CAPITAL STRUCTURE

Q.1. A and B are two firms which belong to a risk class where equity capitalization of 10% is considered
appropriate. ‘A’ has raised Rs 30,00,000 while ‘B’ has raised Rs 50,00,000 by issue of 7% debt. Find out
the value of two firms applying Net income approach given that the expected EBIT for both firms is Rs
6,00,000. Also find their overall capitalization rate.

Q.2. The following information is available with respect to a company:

EBIT Rs 6,00,000
Interest on 8% Debentures Rs 2,00,000
Tax rate Nil
Cost of equity 12.5%
Calculate overall cost of capital and value using Net income approach.

Q.3. L ltd. and H ltd. belong to the same risk class where equity capitalization rate of 12% is considered
appropriate. Both firms expect operating profit of Rs 5,00,000. L ltd. has raised Rs 20,00,000 and H Ltd.
Rs 40,00,000 by way of 9% debt. Find out income and WACC for both firms assuming NI approach.
Which firm has more value and why?

Q.4. X Ltd. Has issued 8% debentures of Rs 300,00,000. It has operating profits of Rs 50,00,000. It
belongs to a risk class where the appropriate capitalization rate is 10%. Find out the value of the firm
and cost of equity applying NOI approach. What would happen if the firm increases debt to Rs
400,00,000?

Q.5. X ltd. has EBIT of Rs 4,00,000. The firm currently has outstanding debt of Rs 15,00,000 and cost of
debt of 10%. The cost of equity is estimated at 16%.
a. Determine the current value using traditional approach.
b. Determine overall cost of capital.
c. The firm is considering to issue capital of Rs 5,00,000 in order to redeem Rs 5,00,000 debt.
The cost of debt shall remain same. However, cost of equity shall come down to 14% as a result
of decrease in leverage. Would you recommend the proposed action?

Q.6. Companies U and L are identical in every respect except that U is unlevered while L has Rs
20,00,000 of 8% debt. EBIT of both firms is Rs 6,00,000 and tax rate is 35%. Equity capitalization rate for
U is 10%. Calculate the value of each firm according to MM approach and cost of equity for L company.

Q.7. There are two companies L ltd. and U ltd. They are identical in all respects except in terms of their
capital structure as can be observed from below:
L ltd. U ltd.
EBIT Rs 1,00,000 Rs 1,00,000
12% Debentures Rs 5,00,000 Nil
Cost of equity 20% 16%
Calculate the value of two firms and illustrate using MM model how an investor holding 10% shares of L
ltd. will be benefited by switching over his investment from L to U ltd.