Ch.

15: Capital Structure Theory and Policy

CHAPTER 15

CAPITAL STRUCTURE THEORY AND POLICY

Problem 1

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Problem 2

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Arbitrage:
Investment in L's shares 5%
Investment value: 5% x 320,000 16,000
Return from the investment: 5% x 48,000 2,400

Sell shares in L (cash inflow) 16,000

Borrow equal to 5% of U's debt:
5% x (1-0.50) x 400,000 10,000
Total available cash 26,000
Buy 5% of U's shares: 5% x 480,000 24,000
Remaining cash 2,000
Return:
Return from U's shares: 5% x 72,000 3,600
Less: cost of borrowed funds: 10,000 x 12% 1,200
Net return 2,400

Problem 3

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Problem 4

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I. M. Pandey, Financial Management, 9th Edition, New Delhi: Vikas.

Problem 5

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Problem 6

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Ch. 15: Capital Structure Theory and Policy

Problem 7

X Y
Expected NOI 50,000 50,000
Cost of debt, INT = kd x D 0 10,000
Net income, NI 50,000 40,000
Cost of equity, ke 10.0% 11.1%
Value of shares, E 500,000 360,000
Value of debt, D 0 200,000
Value of the firm, V = E + D 500,000 560,000
Average cost of capital, ko = NOI/V 10.0% 8.9%
D/E ratio 0.0% 55.6%

Cost of capital, ko - MM thesis (given) 12.5% 12.5%

Value of the firm, V - MM thesis: 400,000 400,000
Value of debt, D 0 200,000
Value of shares, E = V - D 400,000 200,000

Problem 8

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I. M. Pandey, Financial Management, 9th Edition, New Delhi: Vikas.

Problem 9

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Problem 10

Target debt-equity ratio 1.0

Target payout ratio 40%
Growth rate 20%
Before -tax ROI 21%
Interest rate 12%
Sales-to-assets ratio 1.8
Tax rate 35%
Sustainable growth
.4[{.21 + (.21 - .12)1}(1-.35)] 7.8%

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Ch. 15: Capital Structure Theory and Policy

Problem 11

Hindustan Lever Limited

(Rs crore)
Year GFA NCA INVST NW Debt NS PBIT INT PAT
1992 330.5 323.1 12.3 333.3 200.3 1221.1 197.0 32.2 60.0
1993 365.6 285.8 51.0 385.7 115.2 1505.0 244.9 27.2 79.8
1994 491.8 299.7 191.5 538.3 146.5 1721.3 327.4 29.5 97.3
1995 563.8 193.0 122.8 638.3 160.2 2039.4 385.2 20.2 122.1
1996 953.6 168.9 328.8 937.5 260.1 2798.8 654.2 57.0 185.2
1997 1035.2 567.2 544.6 1260.8 186.6 3337.8 874.2 33.9 232.0
1998 1273.4 895.3 729.5 1712.4 264.3 6560.7 1130.5 29.3 404.7
1999 1349.7 1151.8 1068.1 2102.6 177.3 7736.8 1420.1 22.4 570.3
2000 1539.4 1087.1 1832.2 2487.6 111.6 9426.1 1668.4 13.2 808.2
2001 1778.3 1349.7 1668.9 3043.0 83.7 10116.5 1865.6 7.7 1079.8
2002 1836.9 1639.0 2397.7 3658.2 58.3 10588.2 2154.4 9.2 1300.3

Capital structure analysis Invstments anf Financing

Year Debt ratio D/E Coverage Capex ∆ INVST ∆ NCA ∆ NW ∆ Debt
1992 37.5% 0.60 6.1 - - - - -
1993 23.0% 0.30 9.0 35.1 38.7 -37.3 52.4 -85.1
1994 21.4% 0.27 11.1 126.2 140.5 13.9 152.6 31.3
1995 20.1% 0.25 19.1 72.0 -68.7 -106.7 100.0 13.7
1996 21.7% 0.28 11.5 389.8 206.0 -24.1 299.2 99.9
1997 12.9% 0.15 25.8 81.6 215.8 398.3 323.3 -73.5
1998 13.4% 0.15 38.6 238.2 184.9 328.1 451.6 77.7
1999 7.8% 0.08 63.4 76.3 338.6 256.5 390.2 -87.0
2000 4.3% 0.04 126.4 189.7 764.1 -64.7 385.0 -65.7
2001 2.7% 0.03 242.3 238.9 -163.3 262.6 555.4 -27.9
2002 1.6% 0.02 234.2 58.6 728.8 289.3 615.2 -25.4

Profitability analysis
Year NS/CE PBIT/NS PBIT/CE PAT/PBIT CE/NW ROE
1992 2.3 16.1% 36.9% 30.5% 1.60 18.0%
1993 3.0 16.3% 48.9% 32.6% 1.30 20.7%
1994 2.5 19.0% 47.8% 29.7% 1.27 18.1%
1995 2.6 18.9% 48.2% 31.7% 1.25 19.1%
1996 2.3 23.4% 54.6% 28.3% 1.28 19.8%
1997 2.3 26.2% 60.4% 26.5% 1.15 18.4%
1998 3.3 17.2% 57.2% 35.8% 1.15 23.6%
1999 3.4 18.4% 62.3% 40.2% 1.08 27.1%
2000 3.6 17.7% 64.2% 48.4% 1.04 32.5%
2001 3.2 18.4% 59.7% 57.9% 1.03 35.5%
2002 2.8 20.3% 58.0% 60.4% 1.02 35.5%

HLL is a highly profitable company. Its sales have been growing and it is adding fixed assets. The company also
invests its surplus funds in securities of its subsidiaries and other companies. HLL has been financing is growth
through equity funds. It has reduced its dependence on debt. Debt ratio has come down to about 2% from about 36% in
1992.

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I. M. Pandey, Financial Management, 9th Edition, New Delhi: Vikas.

Problem 12

Philips India Limited

(Rs crore)
Year GFA NCA INVST NW TD STBB LTB DEBN NS PAT
1990 154.7 82.1 2.1 41.3 116.5 12.1 104.4 56.7 391.2 -8.2
1991 162.1 97.1 7.6 63.6 101.8 16.0 85.8 48.3 523.1 26.7
1992 181.8 122.9 12.2 76.5 114.6 31.1 83.6 41.2 689.5 21.5
1993 232.1 112.8 13.8 129.3 69.3 6.4 52.9 22.8 672.0 9.0
1994 253.1 141.3 13.2 175.9 62.5 12.8 39.6 3.2 1092.7 33.7
1995 319.2 223.4 14.7 187.4 169.7 91.3 63.4 3.0 1454.4 22.1
1996 376.1 194.3 19.6 190.9 186.9 71.5 100.3 32.7 1438.8 11.8
1997 386.0 175.8 16.7 171.7 168.3 47.6 80.7 32.7 1509.4 44.6
1998 414.8 217.8 15.5 176.2 195.7 44.8 110.9 72.2 1620.1 39.2
1999 330.4 213.1 14.0 191.6 159.9 35.4 104.5 50.0 1662.9 41.4
2000 363.3 134.1 14.0 167.8 127.3 25.8 86.5 53.8 1444.4 -3.1
2001 334.7 40.0 17.3 147.3 66.1 45.9 20.2 0.0 1459.5 40.4
2002 605.4 67.6 1.9 306.4 48.0 5.5 42.5 8.3 1492.8 85.5

Percentage of Capital Employed

Year NS/CE PAT/NS ROE TD STBB LTB DEBN
1990 2.48 -2.1% -19.9% 73.8% 7.7% 66.2% 35.9%
1991 3.16 5.1% 42.0% 61.5% 9.7% 51.9% 29.2%
1992 3.61 3.1% 28.1% 60.0% 16.3% 43.7% 21.6%
1993 3.38 1.3% 7.0% 34.9% 3.2% 26.6% 11.5%
1994 4.58 3.1% 19.2% 26.2% 5.4% 16.6% 1.3%
1995 4.07 1.5% 11.8% 47.5% 25.6% 17.8% 0.8%
1996 3.81 0.8% 6.2% 49.5% 18.9% 26.5% 8.7%
1997 4.44 3.0% 26.0% 49.5% 14.0% 23.7% 9.6%
1998 4.36 2.4% 22.2% 52.6% 12.0% 29.8% 19.4%
1999 4.73 2.5% 21.6% 45.5% 10.1% 29.7% 14.2%
2000 4.89 -0.2% -1.8% 43.1% 8.7% 29.3% 18.2%
2001 6.84 2.8% 27.4% 31.0% 21.5% 9.5% 0.0%
2002 4.21 5.7% 27.9% 13.5% 1.6% 12.0% 2.3%

Over the years Philips has reduced its dependence on borrowed funds. The debt ratio of 74 per cent in 1990 has
reduced to 14 per cent in 2002. The composition of debt has also shown changes over years. The increase in fixed
assets, net current assets and investments has been financed by the shareholders’ funds. Company’s profitability shows
high variability although sales have been growing.

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Ch. 15: Capital Structure Theory and Policy

Case
Case 15.1: Samrudh Company Limited

This case brings out the significance of ratios in analysing a firm’s capital structure in practice. It also
illustrates to use of analytical techniques in evaluating the capital structure changes. The instructor can also
discuss the difference between market value and book value debt ratio and their significance. Also, the
implications of debt covenants could be discussed.

Q1 Book D/E 1.04 Mkt Val D/E 0.55

Curr Ratio 1.00
Inter Cover 4.00

Q2 Curr Ratio will drop to 0.80

High interest cover and low mkt value D/E may make this acceptable to lender

Q3 No. Post tax analysis is against refinancing since tax break is deferred
NPV IRR
Post Tax -1.22 4.40% Computations appear at the end
Pre Tax 0.73 6.71%

Q4 NPV suggests tiny but negative impact of 6 paise in the share price of 35.25
-1.22 ⁄ 21.7 crore shares = -0.06
P/E will suggest large positive impact
deltaPAT= 420 x 5.00% x 65% = 13.65
deltaEPS= 13.65 ⁄ 21.7 = 0.63
P/E 6.67 price rise = 4.20
P/E 8.50 price rise = 5.35

Computation of NPV and IRR

IDBI_loan old_kd new_k kd_post_tax tax_rate prepay_premium

420 14% 9% 5.85% 35% 11%

Post tax analysis

opg prin post tax int diff
prem tax cash flow
2002-03 -46.2 3.234 -42.97
2003-04 420 13.65 3.234 16.88
2004-05 315 10.24 3.234 13.47
2005-06 210 6.83 3.234 10.06
2006-07 105 3.41 3.234 6.65
34.13 -46.2 16.17 4.10
Pretax analysis
opg prin int diff prem cash flow
2002-03 -46.2 -46.20
2003-04 420 21.00 21.00
2004-05 315 15.75 15.75
2005-06 210 10.50 10.50
2006-07 105 5.25 5.25
52.50 -46.2 6.30