Capital Structure | CS Ritika Gupta

Capital Structure – EBIT EPS Relationship

1. Bhaskar Manufacturing Ltd.has equity share capital of Rs.5,00,000(face value Rs.100). To meet the
expenditure of an expansion program, the company wishes to raise Rs.3,00,000 and is having four
alternative source to raise funds:
Plan A: To have full money from the issue of equity shares.
Plan B: To have Rs.1,00,000 from equity and Rs.2,00,000 from borrowings from the financial
institutions @ 10% p.a.
Plan C: Full money from borrowings @ 10% p.a
Plan D: Rs.1,00,000 in equity and Rs.2,00,000 from 8% preference share.
The company is having present earnings of Rs.1,50,000. The corporate tax rate is 30%. Select a
suitable plan from above to raise funds.
[Ans: plan C is preferred]

2. A company has EBIT OF Rs.4,80,000 and its capital structure consist of following securities:
Equity share capital (Rs.10 each) Rs.4,00,000
12% preference shares Rs.6,00,000
14.5%debentures Rs.10,00,000
The company is facing fluctuations in sales. Tax rate is 35%. What would be change in EPS if :
a) EBIT of the company increased by 25% and
b) EBIT of the company decreased by 25%.
[Ans: (a) EPS = Rs.5.59 (b) EPS = Rs.1.69]

3. STD ltd, a software company is an all equity firm having an equity share capital of Rs.20,00,000
divided into shares of Rs.100 each. The company wants to raise an additional funds of Rs. 20,00,000
for its expansion programme. The finance manager has identified following four financing
alternatives to raise the required funds.
a) By raising equity shares only.
b) Rs.10 lakh in equity shares and Rs.10 lakh in debt at 5% rate of interest.
c) All debt at 6% rate of interest.
d) Rs.10 lakh in equity shares and Rs. 10 lakh in preference shares capital with 5% rate of dividend.
You are required to suggest the best alternative assuming the estimated EBIT after expansion
programme is Rs.8, 00,000. What will be your opinion if EBIT is reduced to Rs.4, 00,000?

4. A new project is under consideration in Zip Ltd, which require a capital investment of Rs.4.50 crore,
interest on term loan is 12% and corporate tax is 50%. If the debt equity ratio insisted by financial
agencies is 2:1, calculate the point of indifference for the project.
[Ans:Only equity: Rs.45 lakh; EBIT: Rs.54,00,000] [B.COM (H),DU, 2008,2014]

CS Ritika Gupta, Assistant Professor, Department of Commerce, Satyawati College (Eve.)

Contact: ritikagupta.commerce@satyawatie.du.ac.in 1
 Capital Structure | CS Ritika Gupta

5. Try Ltd. Has a requirement of raising Rs.2,00,000 for which the following plans are suggested:
Financial Plans Equity Debt Preference
shares
Plan A 100% - -
Plan B 50% 50% -
Plan C 50% - 50%
The cost of debt and preference shares is estimated to be 8% and the equity shares of face value of
Rs.10 each will be issued at premium of Rs.10 each. The expected EBIT of the firm is Rs.80,000 and
the applicable tax rate is 50%. Find out, for each plan the EPS, the financial break-even level and the
indifference level of EBIT between plan A & B and between Plan A & C.
[Ans: i) BEP: 8000(Plan B); 16,000 (Plan C) ii) EBIT: Rs.16,000 iii) EBIT : Rs.32,000)]
[B.COM(H),DU,2008,2015]
6. The capital structure of Z ltd. of 35,000 equity shares capital of Rs.100 each. The authorized capital
of the company is 60,000 shares. For the financial year ended 31-3-2016, particulars of production,
cost and sales are as follows:
Units produced and sold (@80% level of activity) 50,000
Selling price per unit Rs.20
Variable cost per unit Rs.10
Fixed operating cost per unit Rs.4
In view of emerging opportunities arising out of globalization, Z Ltd. decided to utilize full capacity
to meet the additional demand for its product. This would, however, involve an additional capital of
Rs.15,00,000. As a result of utilization of full capacity, variable cost will be reduced by 10% but fixed
cost will go up by 10%. The additional output can be sold at the existing selling price. The possible
alternative source of finance for the required additional capital would be
i) Entirely by equity shares of Rs.100 each.
ii) Entirely by 6% bonds of Rs.500 each, or
iii) 50% by equity capital and 50% by 6% bonds of Rs.500 each.
Assuming a corporate tax of 40%, which alternative financing scheme will u recommend? Also
calculate all leverages?
[Ans: EPS: Rs.5.61; Rs.6.47; Rs.5.96]B.COM (H),DU,2016]
7. RQ Ltd. is planning an expansion programme which will require Rs.30 crore and can be funded
through one of the three options:
a) Issue further equity shares of Rs.100 each at par.
b) Raise a 15% loan
c) Issue 12% preference shares.
The present paid up capital is Rs.60 crores and the annual EBIT is Rs.12 crores. The tax rate is taken
as 50%. After the expansion plan is adopted, the EBIT is expected to be Rs.15 crores. Calculate the
EPS under all the three financing options indicating the alternative giving the highest return to the
equity share holders. Also determine the indifference point between the equity share capital and
debt financing.
CS Ritika Gupta, Assistant Professor, Department of Commerce, Satyawati College (Eve.)
Contact: ritikagupta.commerce@satyawatie.du.ac.in 2
 Capital Structure | CS Ritika Gupta

[Ans: (a) 8.33 (b) 8.75 (c) 6.5, indifference level EBIT: Rs.13, 50,000] [B.COM (H), 2009]
8. ABLtd. Has decided to change its capital structure. The firm has one crore fully paid up equity
shares. Market price of shares is Rs.50 and is likely to remain the same even after proposed capital
restructuring. The restructuring involves increasing the firm’s existing Rs.9 crore, 10% debt to
Rs.14 crore.
The proceeds will be used to retire the equity. The interest rates on debt is not expected to change
as the debt investors do not perceive the firm to become more risky. Company is in 40% tax bracket.
Calculate that level of EBIT that the firm must earn so that EPS doesn’t change.
[Ans: EBIT: Rs.5,90,00,000] [B.COM(H),2007,2013]
9. PQR ltd. provides the following details:
Installed capacity 150000 units
Actual Production & Sales 100000 units
Selling price per unit Rs1/-
Variable cost per unit Rs0.50
Fixed cost Rs.38,000
Funds required Rs.1,00,000
Capital structure Financial Plans
A B C
Equity shares of Rs.100 each issued at 25% 60% 40% 35%
premium
15% debt 40% 60% 50%
10% Pref shares Rs.100 each - - 15%
Assume Income tax rate 40%. Calculate
a) Degree of operating, combined and financial leverage.
b) The indifference point of plan A & B
c) The financial break even point for each plan and suggest which plan has more financial risk.
[Ans: a) OL = 4.17 , FL = 2,4,6; CL= 8.34,16.68,25 (B) EBIT = 15000 (C)
A=6000,B=9000,C=10,000]
[B.COM(H),2012]
10. The existing capital structure of ABC ltd. is as follows:
Rs.
Equity shares of Rs.100 each 40,00,000
Retained earnings 10,00,000
9% preference shares 25,00,000
7% debentures 25,00,000
The company earns a return (EBIT) of 12% and tax on income is 50%.
The company wants to raise Rs.25,00,000 for its expansion projects for which it is considering
following alternatives:
a) Issue of 20,000 equity shares at a premium of Rs.25 per shares.
b) Issue of 10% preference shares.

CS Ritika Gupta, Assistant Professor, Department of Commerce, Satyawati College (Eve.)

Contact: ritikagupta.commerce@satyawatie.du.ac.in 3
 Capital Structure | CS Ritika Gupta

c) Issue of 9% debentures.
It is projected that the P/E ratios in case of Equity, preference and debenture financing shall be 20,
17 respectively.
Which alternative would you consider to be the best? Give reasons for your choice.
[Ans: EPS = 7.29,4.68,8.125] [b.com (h), 2010]

CS Ritika Gupta, Assistant Professor, Department of Commerce, Satyawati College (Eve.)

Contact: ritikagupta.commerce@satyawatie.du.ac.in 4
 Capital Structure | CS Ritika Gupta

CAPITAL STRUCTURE THEORIES

1) The company has earnings of Rs.3,00,000. The capital structure of the company is having debt of Rs.5,00,000
borrowed at the rate of 9%. Presently the cost of equity capital is 12%. Find the total value of the firm and
the overall cost of capital using Net Income Approach.
[Ans: 11.43%]
2) A company has EBIT of Rs.4,00,000. The capital structure of the company is having debt of Rs.5,00,000
borrowed at the rate of 8%. Cost of equity capital is 12%. Find.
i) Total value of the firm and the overall cost of capital using NI approach.
ii) Value when debts is increased by Rs.2,00,000
iii) Value when debt is decreased by Rs.2,00,000
[Ans: i) 11.4% ii) 11.2% iii) 11.65%]
3) Two firms X & Y are identical in all respect including risk factors except for debt/equity. X has issued 10%
debentures of Rs.18 lakh while Y has issued only equity. Both the firms earn 20% before the interest and
taxes on their total asset of Rs.30 lakh.
Assume a tax rate of 50% and capitalization rate of 15% for all equity firms. Compute the value of company
X & Y using Net Income approach?
[Ans: X = Rs. 32,00,000 & Y = Rs.20,00,000]
4) ABC Ltd. has all equity capital structure with a cost of capital of 15%. The company decides to raise
Rs.2,00,000, 12% debt and use the proceeds to retire equity. The expected level of EBIT is Rs.90,000 which
is expected to remain unchanged. Assuming NI approach assumptions are applicable, calculate value of
equity and debt and value of firm before and after change in capital structure. Also calculate WACC after
change in structure.
[Ans: value of firm: 6,00,000 & 6,40,000 (equity+debt); ko: 15% & 14.06%]
5) S Ltd. and R ltd. are in the same risk class and are identical in all respects except that company S uses debt
while company R does not use debt.
The levered firm has Rs.9,00,000 debentures carrying 10% rate of interest. Both the firm earns 20%
operating profit on their total asset of Rs.15 lakh. The company is in the tax bracket of 35% and capitalization
rate of 15% on all equity shares.
You are required to calculate value of S & R Ltd using Net Income Approach and Net operating income
approach?
[Ans: NI APPROACH - Vale of firm R Ltd: 18,10,000 ; S Ltd:13,00,000; NOI APPROACH – Y LTD: 13,00,000; X
LTD: 16,15,000][B.COM (H), DU, 2012]
6) A Company has EBIT of Rs.3,00,000 and overall cost of capital of 12.5%. The company has debt of
Rs.5,00,000 borrowed at the rate of 8%. Find the value of company using NOI approach and show using NOI
approach, how change in debt by Rs.3,00,000 have impact the cost of equity of the company.
[Ans: ke: 13.68% ; 14.75%(with increased debt) ; 12.91% (with decreased debt)] [B.COM(H), DU, 2013]

CS Ritika Gupta, Assistant Professor, Department of Commerce, Satyawati College (Eve.)

Contact: ritikagupta.commerce@satyawatie.du.ac.in 5
 Capital Structure | CS Ritika Gupta

7) The net operating profit of the firm is 210000 and the total market value of its 12% debt is 300000. The
equity capitalization rate of an unlevered firm of the same risk class is 16%. Find out the value of the levered
firm given that the tax rate is 30% for both the firms.
[Ans: Levered firm: Rs.9,18,750; Unlevered firm : Rs. 10,08,750]
8) Two companies are identical to each other except that S Ltd. has debt of Rs. 4,00,000 at the rate of 8%
whereas R Ltd. has no debt in its capital structure. The total asset of both the company amount to
Rs.25,00,000 on which company earns 20%. Find the following if both the companies are in the tax bracket
of 40%
a) Value and overall capital if company using NI Approach assuming Ke= 15%.
b) Value of the companies using NOI approach taking Ke of R ltd. (unlevered firm) as 15%.
c) Overall cost of capital of S LTD.(Levered firm) using NOI / MM approach.
[Ans: a) value : 22,72,000 (S); 20,00,000 (R ) Ko: 13.20%,15% ; b) R: 20,00,000 S: 21,60,000 c) 13.89%]

9) Company U and L are identical in every respect except that U is unlevered while L has 8% debt of Rs.20 lakh.
EBIT of both firm is 6 lakh and tax rate is 35%. Equity capitalization rate for U is 10%. Calculate the value of
firm as per MM approach and cost of equity of L ltd.
[Ans: value: 3,90,000;L – 2,86,000; Ko: 8.48%]
10) Two firms X & Y are identical in all respect except the degree of leverage. Firm X has 8% debentures of
Rs.20,00,000. Operating profit of both firm is Rs.6,00,000 and tax rate is 45%. Equity capitalization rate of Y
is 10%. Calculate the value of each firm according to MM approach and cost of capital of X Ltd. Also compute
the overall cost of capital of X Ltd.
[Ans: X: 42,00,000 Y: 33,00,000, Ko: 7.85%][B.COM (H), DU, 2015]
11) L & U Ltd. are identical except that L ltd has issued 10% debentures of Rs.9,00,000 while U has only equity
shares in its capital structure. Both the firms has operating profit of 3,00,000. Assume capitalization rate of
15% for all equity firms:
a) Compute the value of two firms using NI Approach
b) Compute the value of two firms using NOI approach.
[Ans: a) Rs.23,00,000 , Rs.20,00,000 b) 19.09% , 15%][B.COM (H), DU, 2015]

CS Ritika Gupta, Assistant Professor, Department of Commerce, Satyawati College (Eve.)

Contact: ritikagupta.commerce@satyawatie.du.ac.in 6
 Capital Structure | CS Ritika Gupta

12) Two companies V & L, belong to same risk class. These two firms are identical in all respect except that V
company is unlevered while co. L has 10% debentures of Rs.5,00,000. The other relevant data regarding their
valuation and capitalization rates are as follows:
Particulars L (Rs.) U (Rs.)
EBIT 1,00,000 1,00,000
Less: Interest 50,000 -
EBT 50,000 1,00,000
Equity capitalization rate 0.16 0.125
Market value of equity (Ke) 3,12,500 8,00,000
Market value of debt 5,00,000 -
Total market value 8,12,500 8,00,000
Overall cost of capital (Ko) 0.123 0.125
Debt – Equity ratio 1.6 -
a) An investor owns 10% equity shares of company L. Show the arbitrage process and amount by which
he could reduce his outlay through the use of leverage.
b) According to Modigilani and Miller, when will this process come to an end?
[Ans: a)fund saved Rs.1250 and income- Rs.5000 b) when difference b/w L & U comes to zero][B.COM
(H), DU, 2011.2012]
13) Two companies X and Y belong to same risk class. They have everything in common except that firm Y has
12.5% debentures of Rs.12,00,000. Following information about the two firms is available to you:
Particular’s X LTD. Y LTD.
Net operating income 3,00,000 3,00,000
12.5% debt funds 12,00,000
Equity capitalization rate (Ke) 15% 16%

Calculate the value of two firms and explain how Modimiglani Miller approach an investor who owns 10%
equity shares of the overvalued firm will be better off switching his holding of the other firm. Also explain
when arbitrage process will come to an end.
[Ans. VOF : X= 20,00,000; Y= 21,37,500 ; amount of reduced outlay : 13,750][DU,2017]

CS Ritika Gupta, Assistant Professor, Department of Commerce, Satyawati College (Eve.)

Contact: ritikagupta.commerce@satyawatie.du.ac.in 7