Capital Structure Problems

Q.1

The Net Sales of Apex Co. are ₹ 15 crores.

EBIT of the company as a percentage of Net Sales is 12%. The capital employed comprises
₹ 5crores of equity, ₹ 1 crore of Cumulative Redeemable Preference Shares bearing 13%
rate of dividendand Debt Capital of ₹ 3 crores at an annual interest rate of 15% and corporate
income tax rate is 40%. Required :
(1) Calculate Return on Equity (ROE) for the company and indicate its segments due to
thepresence of Preference Share Capital and Debt Capital.
(2) Calculate the Operating Leverage of the Company given that its combined leverage is
3.

Q.2 The existing capital structure of XYZ Ltd. is as under :

Equity Shares of ₹ 100 each ₹ 40,00,000
Retained Earnings ₹ 10,00,000
9% Preference Shares ₹ 25,00,000
7% Debentures ₹ 25,00,000
The existing rate of return on the company’s capital is 12% and the income
tax rate is 50%. The company requires a sum of ₹ 25,00,000 to finance its
expansion programme forwhich it is considering the following alternatives :
• Issue of 20,000 qE
quity Shares at a premium of ₹ 25 per share.
• Issue of 10% Preference Shares.
• Issue of 8% Debentures.
It is estimated that the Price Earning Ratio in the cases of equity, preference
andDebenture financing would be 20, 17 and 16 respectively.
Which of the above alternatives would you consider to be the best?
(b) Give reasons for your choice in (a) above.
Q .3 XY Ltd. provides you with the following figures :

₹
Profit 2,60,000
Less : Interest on Debentures @ 12% 60,000
2,00,000
Less : Income Tax @ 50% 1,00,000
Profit after tax 1,00,000
Number of Equity Shares (of ₹ 10 each) 40,000
EPS (Earning Per Share) 2.50
Ruling Price in Market 25
PE Ratio (i.e. Price/EPS) 10
The company has undistributed reserves of ₹ 6,00,000. The company needs ₹ 2,00,000
forexpansion. This amount will earn at the same rate as funds already employed. You are
informed that a debt equity ratio ( D e b t t o t o t a l C a p i t a l ) higher than 35% will
push the P/E Ratio down to 8 and raise the interest rate on additional amount borrowed to
14%. You are required to ascertain the probable price of the share
 (i) if the additional funds are raised as debt;
(ii) if the amount is raised by issuing Equity Shares.

Q.4 The capital structure of JCPL Ltd. is as follows :

₹
Equity Share Capital of ₹ 10 each 8,00,000
8% Preference Shares of ₹ 10 each 6,25,000
10% Debentures of ₹ 100 each 4,00,000
18,25,000
Additional Information :
Profit after tax (tax rate 30%) ₹ 1,82,000.
Operating expenses (including depreciation ₹ 90,000) being 1.50
times of EBITEquity Share dividend paid 15%.
Market price per equity
share ₹ 20.Require to
calculate :
(i) Operating and financial lev
(ii) Cover for the preference an equity share of dividends
(iii) the earning yield and price earnings ratio
(iv) The net fund flow

Q.5 EXE Limited is considering three financing plans. The key information is as follows :
(a) Total investment to be raised ₹ 2,
(b) Plans of Financing Proportion :
Plans Equity Debt Preference Shares
A 100% -- --
B 50% 50% --
C 50% -- 50%
(c) Cost of Debt 8%
Cost of Preference Shares 8%
(d) Tax Rate 50%
(e) Equity Shares of the face value of ₹ 10 each will be issued at a premium of ₹ 10 per share.
(f) Expected PBIT is ₹ 80,000.
Determine for each plan :
(i) Earning Per Share (EPS) and
(ii) The financial break even point.
(iii) Indicate if any of the plans dominate and compute the PBIT range among the plans
forindifference.
Q.6 Hypothetical Ltd. is in need of ₹ 1,00,000 to finance its increased net working capital
requirements. The finance manager of the company believes that its various financial costs
and share price will be unaffected by the selection of a particular plan, since a small sum is
involved.
Debentures will cost 10 per cent, Preference Shares 11 per cent and Equity Shares can be sold for ₹ 25per share.
The tax rate is 35 per cent.
Sources of Funds Financial Plans (per cent)
1 2 3
Equity Shares 100 30 50
Preference Shares 0 10 20
Debentures 0 60 30
 (i) Determine the financial break even point.
(ii) Which plan has greater risk? Assume EBIT level of ₹ 50,000.

Q.7 A new project consideration by your company requires a capital investment of ₹ 150 lakh. The required funds
can be raised either through the sale of Equity Shares or borrowed from a financial institution. Interest on term loans
is 15 per cent and tax rate is 35 per cent. If the debt-equity ratio insisted by the financing agencies is 2 : 1, calculate
the indifference point for the project. Explain its meaning. Also prepare a verification table.

Q.8 The Modern Chemicals Ltd. requires ₹ 25,00,000 for a new plant. This plant is expected to yield earnings
before interest and taxes of ₹ 5,00,000. While deciding about the financial plan, the company considers the
objective of maximizing earnings per share. It has three alternatives to finance the project – by raising debt of ₹
2,50,000 or ₹ 10,00,000 or ₹ 15,00,000 and the balance, in each case, by issuing Equity Shares. The company’s
share is currently selling at ₹ 150, but is expected to decline to ₹ 125 in case the funds are borrowed in excess of ₹
10,00,000. The funds can be borrowed at the rate of 10% upto ₹ 2,50,000, at 15% over ₹ 2,50,000 and upto ₹
10,00,000 and at 20% over ₹ 10,00,000. The tax rate applicable to the company is 50%.
ANALYSE, which form of financing should the company choose?

Q.9 Ganesha Limited is setting up a project with a capital outlay of ₹ 60,00,000. It has two alternatives in
financing the project cost.
Alternative – I : 100% equity finance by issuing Equity Shares of ₹ 10 each.
Alternative – II : Debt-equity ratio 2 : 1 (issuing Equity Shares of ₹ 10 each)
The rate of interest payable on the debts is 18% p.a. The corporate tax rate is 40%.
Calculate the indifference point between the two alternative methods of financing.

Q.10 Yoyo Ltd. presently has ₹ 36,00,000 in debt outstanding bearing an interest rate of 10 per cent. It wishes to
finance a ₹ 40,00,000 expansion programme and is considering these alternatives:
additional debt at 12 per cent interest, Preference Shares with an 11 per cent dividend and the issue of Equity
Shares at ₹ 16 per share. The company presently has 8,00,000 shares outstanding and is in a 40 per cent tax bracket.
(a) If earnings before interest and taxes are presently ₹ 15,00,000, what would be earnings per share for the three
alternatives, assuming no immediate increase in profitability?
(b) Develop an indifference chart for these alternatives. What are the approximate indifference points? To check
one of these points, what is the indifference point mathematically between debt and common?
(c) Which alternative do you prefer? How much would EBIT need to increase before the next alternative would
be best?

Q.11 Key information pertaining to the proposed new financing plans of Hypothetical Ltd. is
given below.
Sources of Funds Financing Plans
1 2
Equity 15,000 shares of ₹ 100 each 30,000 shares of ₹ 100 each
Preference Shares 12%, 25,000 shares of ₹ 100 each --
₹ 5,00,000 at a coupon rate of 0.10
Debentures ₹ 15,00,000 at a coupon rate of 0.11
Assuming 35 per cent tax rate
(i) Determine the two EBIT – EPS coordinates for each financial plan.
(ii) Determine the (a) indifference point, and (b) financial break-even point for each financing plan.
(iii) Which plan has more financial risk and why?
(iv) Indicate over what EBIT range, if any, one plan is better than the other. I
(v) If the firm is fairly certain that its EBIT will be ₹ 12,50,000, which plan would you recommend,
and why?
 Capital Structure Theory Problems
Q.1 Laxmi Ltd. is expecting an annual earnings before the payment of interest and tax of ₹
2 lacs. The company in its capital structure has ₹ 8 lacs in 10% Debentures. The cost of equity
or capitalization rate is 12.5%. You are required to calculate the value of firm according to NI
Approach.Also compute the overall cost of capital.

Q.2 Assume in the illustration given above that firm decides to raise further ₹ 2 lakhs by the
issue of Debentures and to issue proceeds there of to redeem the Equity Shares. You are
required to calculate the value of firm according to NI approach. Also compute the overall
cost of capital.

Q.3 Modern Ltd. is expecting an earning before interest and tax of ₹ 4,00,000 and belongs
to risk class of 10%. You are required to find out the value of firm and cost of equity capital
if it employs 8%debt to the extent of 20%, 35% or 50% of the total financial requirement of ₹
20,00,000.

Q.4 Ganesh Ltd. is expecting an EBIT of ₹ 3,00,000. The company presently raised its entire
fund requirement of ₹ 20 lakhs by issue of equity at a capitalization rate of 16%. The firm is
now contemplating to redeem a part of capital by introducing debt financing. The firm has two
options – toraise debt to the extent of 30% or 50% of total funds. It is expected that for debt
financing upto 30% the rate of interest will be 10% and equity capitalization rate is expected
to increase to 17%. However,if firm opts for 50% debt, then interest rate will be 12% and
equity capitalization rate will be 20%.
You are required to compute value of firm and its overall cost of capital under different
options.

Q.5 Zenith Ltd. is presently financed entirely by Equity Shares. The current market value is
₹ 6,00,000. A dividend of ₹ 1,20,000 has just been paid. This level of dividend is expected to
be paid indefinitely. The company is thinking of investing in a new project involving an outlay
of ₹ 5,00,000 now and is expected to generate net cash receipts of ₹ 1,05,000 per annum
indefinitely. The project would be financed by issuing ₹ 5,00,000 Debentures at the market
interest rate of 18%.
Ignoring tax consideration :
(1) Calculate the value of Equity Shares and the gain made by the shareholders if the cost
of equity rises to 21.6%.
(2) Prove that the weighted average cost of capital has not been affected by gearing.

Q.6 Companies U and L are identical in every respect, except that U is unlevered while L is
levered.Company L has ₹ 20 lakh of 8 per cent Debentures outstanding.
Assume :
(1) That all the MM assumptions are met.
(2) That the tax rate is 35 per cent
(3) That EBIT is ₹ 6 lakh and that equity-capitalisation rate for company U is 10 per cent.

(a) What would be the value for each firm according to the MM’s approach?
(b) Suppose VU = ₹ 25,00,000 and V1 = ₹ 35,00,000. According to MM, do they represent
equilibrium values? If not, explain the process by which equilibrium will be restored.
Q.6 RES Ltd. is an all equity financed company with a market value of ₹ 25,00,000 and
cost of equity Ke = 21%. The company wants to buyback Equity Shares worth ₹ 5,00,000 by
issuing and raising 15% perpetual debt of the same amount. Rate of tax may be taken as
30%. After the capital restructuring and applying MM Model (with taxes), you are required
to calculate :
(i) Market value of RES Ltd.
(ii) Cost of Equity Ke.
(iii) Weighted average cost of capital and comment on it.

Q.8 Stopgo Ltd., an all equity financed company, is considering the repurchase of ₹ 200 lakhs
equity and to replace it with 15% debentures of the same amount. Current market value of the
company is ₹ 1140 lakhs and its cost of capital is 20%. Its earnings before Interest and Taxes
(EBIT) are expected to remain constant in future. Its entire earnings are distributed as dividend.
Applicable tax rate is 30 per cent. You are required to calculate the impact on the following
on account of the change in the capital structure as per Modigliani and Miller (MM)
Hypothesis :
(i) The market value of the company
(ii) Its cost of capital, and
(iii) Its cost of equity.

Q.9 Alpha Ltd. and Beta Ltd. are identical except for capital structures. Alpha Ltd. has 50 per
cent debt and 50 per cent equity, whereas Beta Ltd. has 20 per cent debt and 80 per cent equity.
(All percentages are in market-value terms). The borrowing rate for both companies is 8 per
cent in a no- tax world, and capital markets are assumed to be perfect.
(a) (i) If you own 2 per cent of the shares of Alpha Ltd., what is your return if the company
has net operating income of ₹ 3,60,000 and the overall capitalization rate of the
company, K0 is 18 per cent?
(ii) What is the implied reuqi red rate of return on equity?
(b) Beta Ltd. has the same net operating income as Alpha Ltd.
(i) What is the implied requi red equity return of Beta Ltd.?
(ii) Why does it differ from that of Alpha Ltd.?

Q.10 There are two companies N Ltd. and M Ltd., having same earnings before interest and
taxes i.e. EBIT of ₹ 20,000. M Ltd. is a levered company having a debt of ₹ 1,00,000 @ 7%
rate of interest. The cost of equity of N Ltd. is 10% and of M Ltd. is 11.50%.
Find out how arbitrage process will be carried on?

Q.11 One-third of the total market value of Sanghmani Ltd. consists of loan stock, which has
a cost of10 per cent. Another company, Samsui Ltd. is identical in every respect to Sanghmani
Ltd., except that its capital structure is all-equity, and its cost of equity is 16 per cent.
According to Modigliani andMiller, if we ignored taxation and tax relief on debt capital, what
would be the cost of equity of Sanghmani Ltd.?
Q.12 The following data relate to two companies belonging to the same risk class :
Particulars A Ltd. B Ltd.
Expected net operating income ₹ 18,00,000 ₹ 18,00,000
12% Debt ₹ 54,00,000 --
Equity Capitalization Rate -- 18%
Required :
(a) Determine the total market value, Equity capitalization rate and weighted average cost
of capitalfor each company assuming no taxes as per MM. Approach.
(b) Determine the total market value, Equity capitalization rate and weighted average cost
of capitalfor each company assuming 40% taxes as per M.M. Approach.