ara CAPITAL STRUCTURE By: CA Ashish Kalra (2) The Debt/Equity ratio is: Vo = £20,000,000 = 0.31.58 Ve %63,333,333 (©)(1) Ve = Ve Vo = 83,333,333 - £30,000,000 = *53,333,333, J = EAR = 210,000,000 - €2,100,000 = 14.81% i ve 153,333,333 (2) The Debt/Equity Ratio is: Vb = £30,000,000 = 0.5625: Ve 53,333,333 sae Gr Lites, operating income is 500,000, The firms cost of debt is 10% and currently firm employs U15,00,800 of debt. The Overall Cost of Capital of the Firm is 15%. You are. required to determine: (1) Total Value of the Firm UE = ERT 3 (ii) Cost of Equity Ned. Solvbten: (i) Etat=ment Showing Value of the Firm % P ‘Around ia © Net Operating Income/EBIT 5,00,000 Less: Interest on Debentures (10% of %15,00,000) 150,000 Earnings Avoilable for Equity Sharehelders 3,50,000 Total Cost of Capital (Ko) (given) 15% Vols of the Firm VF = ESET = %5,00,000 33,33,333 Ko 15% | (ii) Morket value of Debt (D) 15,00,000 | Marl? Volur of Equity Ve = Ve = Vp =*33,33,333 - 215,00000 | 18,33,333 (i)Co-t of equity (Ye) = Earrings Avoilable. for Equity Holders Market Value of Equity = EOIT= Interest Paid on Debt = %5,00,000 - ®1,50,000 = _%3,50,000 - 19.09% or, ‘Market Value of Equity 218,33,333 718,33,333 o* ton a Z Ltd’s operating income (before interest and tax) is 9,00,000. The firm's cost of debts is 10 percent and curtént firm employs %30,00,000 of debts. The overall cost of Capital of firm is 12 percent. Required: Calculate cost of equity. (CAPCCNev 2007) (Ameunt in) EBIT 9,00,000 Less: Interest (10% x 30,00,000) Value of Firm = EBLT = £9,00,000 Ko 12% Vdlu> of Equity = Value of Firm - Value of Debt. = €75,00,000 - %30,00,000 = 845,00,000 t¢=__. eT. 26,00,000 = 13.33% feu ered 'y_*45,00,000 “ORTES OF CAPLTALISTRUCTURE: TRAI YACH-& MA T. AI ovo-sian 31: ABC Co, has a total capital of %2,50,000, The financial manager of the firm wants Yo take a decision regarding Yphe copital structure. After a study of the capital market, he gathers the following data: ‘Amainnt af Debt @)__| Interest Rate (%4) | Equity Capitalisation Rate (at aiven level of debt) (%) 0 2 10.00 50,000 80 1050 100,000 80 11.00 2 1,50,000 90 1150 | 2,00,000 95, 12.30 | You are required to (i) Determine the weighted average cost of capital and optimum capital structure by traditional ion rateif |) approach (the firm always meintains its copital structure at book values). (i) Determine equity cop Modiclian’ Miller approach is followed. Colition: (i) As per the traditional approach, optimum copital structure exists when the weighted average cost of capital a ‘ic minimum. The weighted average cost of capital at book value weight is as follows: | [kee We: We x ke (%) Ka Wa. Wa x kd) Ko) 100 10 10 — = 2 10 i10% “| 10% + (10% - 0%) ° 1% | Wh e(o%-ax) | F000 | ioe, 10% | t0%+(10%-%) | 1.00000 10% 113% 10% | 10%+(10%-9%) pC ito 10% + (10% - 9.5%) 12% ent; {W) Mid-Air pays out all ofits income a dividends; () Tf Mid-Air begins to use debt, it of can borrow at the rate kd = 8%, This borrowing rate is constant ond itisindependent 4 the amount of debt used, Any money raised by selling debt would be ard ra retire common stock, so Mid-Air assets 4 Would remain constant; (Wi) The risk of Mid-Air's assets, and thus its EBIT, is such that its shareholders require arate of return ke=12%ifno 4 debt is used. Ve Using MM Medel without corporate taxes and assuming a debt of &1 crore, you are required to: 4 (@) Determine the Firm's Total Market Value: 4 (b) Determine the Firm's Value Of Equity: « {c) Determine the Firm's Leveraged Cast of Equity, 4 Solution: (0)Firm’s Total Market Value \ o Ve =EBIT = %24,00.000 = #2 crores ( thecause hous Here ie ne othe capital) Cee eat 4 -EBLT = £24,00.000 a ee et at ke Oz Ke = ko 4 (©) Firm's Market Value of Equity ——_ Ve = Ve~Vo_= 82 crores = €l crore = & crore 4 $0) Finm’s Leverage Cost of Equity 12% = (2k BU) lees 1 4 4 33: 00 9 rae aes before interest and toxes ie: EBIT of %20,000. Firm M4 Race levered company having a debt of %1,00,000 © 7% rate of interest, The cost of equity of N company is 10% and of 1 ‘Company is 11.50%, Find out how arbitrage process will be carried on? 4 ‘Solution: Value of Firm N = EBLT = £20,000 = %2,00,000 4 Ko 10% Value of Firm M = Value of Equity + Value of Debr 4 4 For Classes & Information: Visit www.igpinstitute aro & downland TCD snCAPITAL STRUCTURE By: CA Ashish Kalra c=: « Value of Deb = ¥20,000 = £7000 + #1,00,000 = 21,13,043 + *1,00,000 = x2.13,043, Ke 115% “i ‘A ‘7 Suppose, on investor holds 10% shares in Firm M ‘Therefore, his investment of 10% in equity of levered firm = 10% x %113,043 = €11,3043 And, his urn from Firm M = 10% of (20,000 - *7,000) =” bitraae Gain: Sell his present 10% investment in Firm M for €11,304.3. Also, in order to maintain the same level of financial risk, he should borrow funds = 10% of levered firms debt ie. 10% of 4) %1,00,000 = %10,000 at 7% rate of interest, Therefore, total resources available for investment = €11,304.3 + £10,000 = %21,304.3 The investor wil earn same return os lst in Firm M on holding 10% shares in Firm N, which has been explained as follows: 5” | Dividends received from Firm N (10% x £20,000) = %2,000 & (J) Interest on personal debt (7% x 10000) = (®700) Net Income from Firm N 1,300 4 The arbitrage gain will be earned by the investor on investment of remaining cash of %1,304.3 in Firm N. Arbitrage Gain = (*1,304.3 x 10%) = %130.43. The investor con invest the total cash available with him of €21,304.3 for investing in Firm N. Therefore, the investor holds £21 304,3 = 10,652% shares in Firm N %2,00,000 Firm N after transfer: Na ‘Amount in & Dividends receivable from firm N (&20,000 x 10.652%) 213040 Less: Interest to be paid on personal borrowings (810,000 x 7% 1,430.40) Thus, on investor wil earn a net arbitrage gain by switching from firm M to firm N = 1,430.40 - 81,300 = %130.40 sso. 24: There ore two firms U and L having same NOI of 220,000 except that the firm L is a levered firm having a aREFaFITOO,000 © 7% ond cost of equity of U & L are 10% and 18% respectively. Show how arbitrage process will work ' ' , ’ » > > 5 D D 5 >. Pp += ¥20,000 - £7000 + &1,00,000 = 872 222 + %1,00,000 = %1,72,222 . 18% ‘Suppose, on investor holds 10% shares in Firm U. 1D Therefore, value of his investment of 10% in equity shares of unlevered firm = 10%. x %2,00,000 = 20,000 2 And, his present return from firm U = 10% of £20,000 = %2,000 o> 49 econ orbitrage gain: The investor will sell his present 10% investment in, Firm U for 20,000. He will earn the e same return os lost in Firm U by investing in 10% shares of Firm L & lending debt equal to 10% of debt of Firm L which can be explained below: (P __ dividends received from Firm L [10% x (®20,000 - &7:000)] 21,300 o 2700 7000 @ ‘The remaining uninvested amount of €2,778 (i.e. €20,000 - 17,222) will be invested in Firm B's shares alongwith risk free "| lending (dividends receivable (%2,778 x #72222 x 213,000 220969 F @ ‘U72,222 «72,222 b Interest earned %2.778 x _%1,00,000 x _%7,000 1291 @ $72,222 _%1,00,000) Net Arbitrage Gain 2322.60 e Inorder to maintain the some level of financial risk, he decides Yo Tend at 7% rate of interest whichis same as Firm @ Us cost of debt = %20,000 x 100,000 = 11,613 z72222 2 ‘Thus, the remaining amount out of %20,000 ie % (20,000 - 11,613) (¢) Interest receivable on personal lending of €10,000 (®10,000 x 7%)pa err f Ashish Kalra CAPITAL STRUCTURE By: CA Income from Firm L after transfes Particulars ‘Amount in & Dividends (ome of 81,00,000 x nat?) 1,510 72,222 - __| Add: Interest receivable on personal lending (%11,613 x 7%) 813 Total Income 2.323 = ¥2,323 - %2,000 = €323 © Question 39Aipha Limited and Beta Lnited are identical except for capi m be aw e The jing rate "50% equity, wRéreas Beta has 20% debt and 80% equity. (All percentages are in pee terms). The borrowing f for both companies is 8% ina no-tax world, ond capital markets are assumed tobeperfect. = 4¢ 23,60,000 | Obs is if the company has net operat (©) (i) Tf you own 2% of the stock of Alpha, what is your ca abe ae he er cae of ene eur | 10? (il = and overall capitalisation rate of the company, Ko is 18%? (i : AD (©) Beta has the same net operating income & Ko as Alpha (i) What is the implied required equity return 0 Why does it differ from that of Alpha? ‘Solution: (c) (i) Compuration of Earnings Available for Eqult Ethhis!n i i firm U to firm L Sharsholders Particulars Aimount in % Net Operating Income 3,60,000 ; | + Overall Capitalisation Rate 0.18 Total Value of Firm 0,00,000 Less: Market Value of Debt (50%) (10,00,000) Market Value of Stock (00%) 10,00,000 Net Operating Income 3,60,000 , Less: Interest on Debt (8%) (60,000) Earnings Available for Equity Shareholders 2,80,000 "Return =2% of %2,80,000 = @ 5,600. . (ii) Implied Required Equity Return = %2,80,000 = 28% F 210,00,000 ‘ (b)(i) Computation of Earnings Available for Equity Shareholders ; Particulars: Amount in © Total Value of Firm 20,00,000 4 Less: Market Value of Debt (20%) (4,00,000) ‘Market Value of Equity (60%) 16,00,000 ( Net Operating Income 3,60,000 p Less: Interest on Debt (8%) |___(@2,000) | Earnings Available for Equity Shareholders 3,26,000, 4 Implied required equity return = £328,000 = 205% 216,00,000 \ | __ (i) Tris lower because Beta uses less debt in its copital structure. As the equity capitalisation is a linear function of the 4 debt-to-equity ratio when we use the net operating income approach, the decline in required equity return offsets exactly not employing so much in the way of “cheaper” debt funds. 7 G OF CAPITAL STRUCTURE: MM IE APPROACH, ‘ f Questjéh 36: ‘There are two firms Company A and B having net operatit some of 15,00,000 each. Company 8 is a levered - compény whereas Compary A is all equity company. Debt employed by Company 8 is of &7,00,000 @ 11%. The tax rate . cpplicable to both the compares is 25%, Calculate earnings avalebe for equity and debt for both the firms. Solution: Statement of calculation of Earnings Available to Equity Holders and Debt Holders (aiacui i ‘ (Parteuors cain ae ‘ ‘Net Operating Income 15,00,000 75,00,000 Less: Interest on Debt (11% of 27,00,000) 2 (77,000) Profit Before Taxes 15,00,000 14.23 Pesce (3.75,000) (3.55,750) Profit After Tax/Earnings Available for Equity Holders 11,25,000 0 , Total Earnings Available for Equity Holders + Debt Holders 11,25,000. 10,67,2 For Classes 4 Information: Visit www lopinstitute.org & download TEP Mobile App ‘| CPECCVCVCCUVUVCVVVYVVVVVVWVVYMVTT Eww ~~ T oy? ASDIsh Kalra AS we can see that the earni 'ngs in case of Company Bis more than the earninas f Company A because of tax si 4 faba , any A because of tax shield available oe ees ot Comary B due tothe presence of debt structure in Company 8, The intrest s deducted fron fee of Bath the nace atthe corporate level equity holderselzo get thei icome after tox deduction uefa atic wane, ree re eres tothe extent of tax saving onthe interest paid i. tox shield ie. 25%» £77,000 = €19 250 in the income of two companies’ earnings ie. 11 44,250 = 21,25 000 = %19,250, ee ES Ltd. isan all equity financed campany with « market value of €25,00,000 and cast af equity, Ke The co : AY nts to buyback equity shares worth %5,00,000 by issuing and raising 15% perpetual debt of the same. unt. Rate of tax may be token as 30%, After the coptal restructuring ond pplying MM Medel (with taxes), you are. quired to coleulate (i) Market Value of RES Ltd. (i) Cost of Equity Ke, (i) Weighted Average Cost of Capital and Comment oni ‘tion: Conputation of Market Value, Cost of Equity and WACC of BES Ltd, Volue of Equity =%25,00,000; ke = 21% Net Ir Enuity Holders = Morket Value of Equity Net Tncome (NE) for Eauity Holder = €25,00,000 oz Net Income for Equity Holders = %5,25,000 EBIT = &5,25,000 = 27,50,000 (CATPCC Mey 2012) ou (Amount in) Hectic All Equity | Debt and Equlty. eBrT 750,000 50,000 Less: Interest to debt-holders (0) (75,000) EBT 7,50,000 675,000 Less: Taxes (30%) 2,25,000) (2,02,500) Income Available for Equity Shareholders 5,25,000 472,500 Inesine to Debt Holders plus Income Available for Equity Shareholders |_5,28,000 5.47,500 Present value of tax-shield benefits = &5 00,000 x 0,30 = &1,50,000 (i) Volue of Restructured firm = €25 00,000 + *1,50,000 = ¢26'50,000 (i) cost of Eauity (he) 4 Total Value 226 50,000 (31 Toup) qo before om Less: Value of Debt |_(%5,00,000) tb a of Equity __['221,50,000 Y if Ke = %4,72500 = 0.219= 22% %21,50,000 (i Cost of Debt (after tax) = 15% (10.3) = 105% Comrenants of Costs | Amount in® | Cost of Copital | Weight | Weighted COC Equity 21,50,000 22% 081 178% Debt ¥ 5,00,000_ 10.5% 0.19 2.0% . 26,50,000 1,00 | _ 19.8% WACC= 19.8% * il 3 nent: At present, the company is all equity financed. So, Ke = Ko ie, 21%, However after restructuring, the Ko would be reduced to 19.8% and Ke would increase from 21% to 21.98%, Reduction in Ko and increase in Ke is good for the health. of the company. OA Question 27 There are two Firms P ond Q which are identical except P does not use any debt ints capital structure — while Q hes #8,00,000, 9% debentures in ifs capital structure. Both the firms have. earnings before interest and tax of. ¥2,60,000 pa. and the equity capitalisation rate of Firm is 10%, Assuming the corporate tax of 30%, calculate the value} of these firms according to MM Hypothesis. (CAPCENov 2009 Adapted) |} Morket Vole of Fitm P (Unlevered): T(T= #) = ¥2i60000 (1-030) = £1,82,000 = 218,20,000 You 10% 10% ‘yinlsat For Classes & Information: Visit www. lopinstitute.ora & download IGP Mobile App 3ab "By: CA Ashish Kaira [LRA ; ne 0 9.30) =18,20,000 + ¥2,40,000 = €20,60,000 detache oy 8 ae ‘are identical in every respect except capital structure.‘A’ Ltd. does not employ debts (DAI assumptior A L058 Ltd. employs 12% Debentures amounting 10 0 lakhs, Assuming that: ms of M-M model are met, | rem 1810 al 7 | Gid.Income Tax Rate is sor H » Wil) EBIT is x2 50, d. © () The Equity _ Calculate the: iB ‘Solution: Val Capitalisation rate of ‘A’ Ltd. is 20%. ‘valk sof both the compas nase find ut the Weighted Average Cost of Capit foe both the companies lue of IT a af Ualevered Firm A Lid! Or Vu EIT (I = Vu= 22.50, 30) =%8 78 : = 030) =%8.75,000 20%. Value oF Levered Firm 8 Ld ered Firm's %8,75,000 + (HOG, 000 Viz Vue Dxt %) 410,00,000 (10.3) = 52% € (000 Kd=T(1- 1) = &120000(1- 03) a NP *10,00,000 = Statement showing Computation of Ke of & Ltd, Particulars ‘Ancint int esIT PaaaG _ | Less: Interest on 12% Debentures (120,000) eer TsO O60) Less: Income Tox @ 30% (39,000) EAT/EAE (A) 91,000 Total Value of Firm 175,000 Less: Value of Debt (19;00,000) Value of Equity (8) 175,000 Ke of B Ltd. (A/(B) 052 ‘Statement showing Canpataiion of WACC of 8 Li ‘Source | Amount int | Weight [ cost | _wace Debt 10,00,000| oasit| 840%] 7.149% Equity 175,000| 01489] 52% |__7.743% 11,75,000 | 1,00 14.692% | aw WACC of B Ltd. = 14.89% us ie. - ES OF 6: STRUCTURE: NE &.NOL APPROACH WETH TAXATION | "Question 40: Firms P and Q are in the same risk class, and are identical in every respect except that Firm P uses debt Ushi firm Q does not. The levered firm has %10,00,000 debentures, carrying 8% rate of interest, Both the firms carn 16% before interest and taxes on their assets of %20,00,000, Assume perfect capital markets, rational investors and so on | Capitalisation rate is © 12% and corporate tax is @ 50%. Calculate the value of firms P and Q using the net income (NI) opproach, Calculate the value of each firm using the net operating income (NOT) approach. ) Using the NOI approach, compute the overall cost of capital (Ko) for firms P and Q. © Solution: (i) Conputation of the Value of Firms P & Q (Amount in @) Particulars Levered Firm P [Unlevered Firm Q EBIT (16% x %20,00,000) 320,000 3,20,000 Less: Interest (8% x %10,00,000) (80,000) 2 Ear. 240,000 320000 “For Classes & Information: Visit www igpinstitute.org & download IP Mobile App> CAPITAL STRUCTURE By: CA Ashish Kalra 5 Less: Tax (50%) (1.20,000) (60,000) | é . ty Holders 1,20,000. 1,60,000 DBE | Exuity copitaisation Rate (ke) 012 O12 > Value of Equity (Ve) 10,00,000 13,33,333 Value of Debt (Vo) 10,00,000 a D sf the Fiem (Ve) 20,00,000 13,33,333 > 9 me value of an unlevered firm under the NOI approach when taxes are considered, can be computed by the following {formula suggested by M-M. | of UNlevened Firm (Vs) = EBIT (1 = } Keu d Firm (4) = Vos dxt pp Accordingly, Value of Unlevered Firm'Q’ can be ascertained as under: Vu= 33,20,000 (1 - 0.5) = $320,000 x05 = 113,33,333 > oz 012 Value of levered firm can be computed as under: D _ v.=413.33.333 + (€10,00.000 x 05) > = %13,33,333 + 25,00,000 = 118, 33,333 Gi) Firm Q: Kou= Keu = 12% DB FirmP: v= = E0rv(1 +) =23,20,000 = 8.727% %18,33,333 Dor To determine the overall cost of capital, cost of debt (Kd) and cost of equity (Ke) are required. 5 Firm Dar exu-05):4% 5. < Availoble to Equity Holders = NI Ve > eguttion 6 (Amount in ° eBIT 3(20,000 , Less: Interest (80,000) Taxable Tneame 2,40,000 > Less: Taxes at 50% 1,20,000 = le to Equity Holders 1,20,000 > Value of firm (Vr) as determined in part (i) 18,33,333 > Value of Debenture (Va) 10,00,000, Maks chicane Soeenrs 3 Ke. = 3120.00 = 14.40% %8,33,333 BD ka = 4%(210,00,000) 14.40% (28,3333 )= 8.727% > 18,33,333 18 33,33. 2 “1 Zion Company has earnings before interest and taxes of *30,00,000 and a 40% tax rate. Its required rate of return on equity inthe absence of borrowing is 18%, 9 (0. Inthe absence of personal foxes, mhat isthe value of the compary in an MM word (with no leverage? (i) with ¥40,00,000 in debt? (ii) with 270,00,000 in debt? b) Personal as well as corporate taxes now exist. The marginal personal tax rate on common stock income is 25% & the . © rporat arg) marginal personal tox rate on debt income is 30%. Determine the value of the company for each of the three debt . alternatives in part (a). Why do your answers differ? 1 Your of Unlvered Firm = E8TT =) = £3,00,000 1-040) = *1,00,00,000 Ko 18% 9 (i) Volue of Firm with 240 00,000 in Debt: . Vi= %1,00,00,000 + %40,00,000 x 40% = %1,16,00,000. > __ (i) Value oF Firm with £70:00,00 in Debt: > VL = %1,00,00,000 + 70,00,000 x 40% = 1,28 00,000. Due to the tax sovings, the firm is able to increase its value in a linear manner with more debt. For Classes & Information: Visit www.igpinstitute.org & download IGP Mobile App