••

7. "Operating risk is as
sociated ·th
C • , , 1;...,1
structure of a busines s con wi • cos_t.structur
. .. e, whereas financial risk
cern. Cntically examine is associated with capit
8. Give a cnt1cal appra this statement. al
problem of capital str isal of the tr dT
uc t I
a ional approach and
ure . the Modigliani-Millers ap
proach to the
9. What do you underst
an d low ge ari ng on an d by capital e . ?
the fi . .
. g anng · What is . .
its significance ? Discuss
10 . "Changes in ca inanc1 al position of the effects of high
•t . . .
a 11sat1on ma y be sought a company durin g various phases of tra
a be tte r opportuPl
nity to pu de cycle.
·t . .
for ch an ge s in ca pit ali rsue I s purpose " as a means of easin g ten sio n
. .
and giving corporation
· n th 8 r19 ht of thi.s sta
sa r I
10n. tement, dis . .
cuss vario us reasons
11 . Us ing Imaginary fig
Approach, an d (b) ure s sh ow ho w to
Th e Ne t .
__ __ _ _ . determine the value of
O perating Inc firm under (a) The Net-In
- ome (NOi} Approach. come (NI}
Ex er ci se s
"l~ ,... ;

,
Ex. 1. X Ltd. a widely he
ld co m
and the following alt ernatives are avai~aan . . . - . ·=
b{e ~s considenng a maJor . .
expansion of its production ~-,
facilities
Alternatives (I ' in Lakhs)
A B
Sh are Capital C
14% Debentures 100 40 20
Lo an @ 18 % p.a 40 30
~x pe cte d rat e of return be 20 50
fore interest and tax is 25%
is n~ t less tha n 20%. The . Toe rate of dividend of the
company at present has a company
W hic h of the alternative no debt. Rate of corporate tax
s would you choose ? is 50%.
[An~. Ra te of return on sh
Alternative C sh ou ld be are capital under alternative
chosen]. s A, Ba nd C: 12 .5% 19.75
% and 29 53/c0
Ex. 2. AB C co mp an y ha ' · resp.
s currently ~n ordin~ry sh
shares of tIO O each._ Th are capital of t 25 lakhs,
e management 1s planm~g consisting of 25,000
programme of ex pa ns ion to rais~ another t2 0 lakhs
through one of four possi to finance a major
ble financial plans. The op
(i) En tir ely thr ou gh ordin tions are :
ary shares.
(ii) t IO lak hs thr ou gh
ordinary shares and tlO
lakhs through long-term
int ere st pe r annum. borrowings at 8%
(iii) t5 lakhs thr ou gh or
dinary shares and fl5 lak
hs through long-term bo
int ere st pe r annum. rrowing at 9%
(iv) ~ IO lakhs thr ou gh
ordinary shares and tlO
lakhs through preference·
dividend. shares with 5%
Th e co mp an y's ex pe cte d
ea rn ing before interest an
corporate tax rat e of 50 d taxes (EBIT) will be t
%, de ter mi ne the earning 8 lakhs . Assuming a
s per share in each altern
alternative is th e be st an ative and comment which
d why.
[Ans. (i) t8 .8 8; (ii)~I0 .29
; (iii) ~11.07; (iv )fl 0.0 0;
Ex. 3. XY Lt d. ne ed s ~ Plan III is the best]
50 ,00 ,00 0 for the installat
to yield an nu al Ea rn ing s ion of a new factory. the
Be fo re In ter es t an d Tax (E new factory is expected
BIT) of f _10,00,0~0. I? ch
Ltd. has an ob jec tiv e of
ma xim isi ng earnings pe r oosing a_ ~n-~cial pl~n, ~
share. It 1s cons1dermg the
poss1b1ht1es of 1ssumg
 Capital Structure
16.62
t 20 00 000 or ?30 00 000. The current market price
ordinary sh~res and rais!ng debt of ?5,00,00 0 or . .' ' are bo~owed in excess of t20,00,000
pl!r share 1s ~300 and 1s expected to drop to ?250 if the funds •
Funds can be raised at the following rates. :
Upto ~5,00,000 at 10%
Over ,5,00,000 to , 20,00,000 at 15%
Over ~ 20,00,000 at 20%
Assuming a tax rate of 50%, advise the company.
[Ans.l.~31.67; II. ~36.25; Ill t 32.81].
The second alternative which gives the highest earnings per share is the best. Hence, the company
is advised to raise ~0,00,000 through debt and ?30,00,000 by ordinary shares.]
Ex. 4. The Hardware Company Ltd. has to make a choice between debt issue and equity issue for
its expansion programme. Its current position is as follows :
~
Debts 5% 20,000
Equity Capital ~IO per share) 50,000
Surpluses 30,000
Total Capitalisation 1,00,000
Sales 3,00,000
Total costs 2.69,000
Income before Interest & taxes 31.000
Interest 1,000
30,000
Income-tax 50% -15,000
Income after taxes 15.000

The expansion programme is estimated to cost t50,000. If this is financed through debt, the rate on
new debt will be 7% and the price--{!arning ratio will be 6 times. If the expansion programme is financed
through equity, new shares can be sold netting t 25 per share, and the price--{!arning ratio will be 7 times.
The expansion will generate additional sales of? 1,50,000 with a return of 10% on sales before interest
and taxes. If the company is to follow a policy of maximising the market value of its shares, which form
of financing should it choose ?
[Ans. Debt form of financing ; Market value of share = t24.90 and ~22.50]
Ex. 5. A company earns a profit of t 1,50,000 per annum after meeting its interest liability of ~
60,000 on 12% debentures. The tax rate is 50%. The number of equity shares of t IO each are 40,000
and the retained earnings amount to ~ 6,00,000. The company proposes to take up an expansion scheme
for which a sum of~ 2,00,000 is required. It is anticipated that after expansion, the company will be
ab_k to ~chieve the same return on investment as at present. The funds required for expansion can be
raised either through debt at the rate of 12% or by issuing equity shares at par.
Required:
(i) Compute the Earnings per share (EPS), if ;
(a) the additional funds were raised as debt ·
'
(b) the additional funds were raised by issue of equity shares.
(ii) Advise the company as to which source of finance is preferable.
[Ans. EPS : Present t 1.875 : When additional funds raised as debt t I 9'J5 . When additional funds
raised as equity t 1.483, Raising of debt is a better source] · - '
Capita/Structure
16~63
Ex. 6. Calculate the level of earnings before interest and tax at which the EPS indifference point
between the following financing activities will occur.
(i) Equity share capital of f 3,00,000 and 10% debentures of t 2,00,000.
Or
(ii) Equity share capital of f 2,00,000, 12% preference share capital of f 1,00,000 and 10%
debentures of f 2,00,000.
Assume that the corporate tax rate is 35% and par value of equity share is t 10 in each case.
[Ans. f 75384.615]
Ex. 7 • A company is planning an expansion program which will require t 60 crore and can be funded
through one of the three following options :
1. lssue further equity shares of f 100 each at par.
2. Raise a 15% loan.
3. Issue 12% preference shares.
The present paid up capital is t 120 crores and the annual EBIT is f 24 crores. The tax rate may
be taken at 50%. After the expansion plan is adopted, the EBIT is expected to be f 30 crores.
Calculate the EPS under all the three financing options indicating the alternative giving the highest
return to equity shareholders. Also determine the indifference point between the equity share capital and
debt financing (i.e., option 1 and option 2 above.)
[Ans. EPS : Option 1 t 8.33 ; Option 2 t 8.75 ; Option 3 t 6.50 Option 2 gives the highest return;
Indifference point between option 1 and 2 t 27 crores]
Ex. 8. A company needs f 31,25,000 for the construction of a new plant. The following three plans
are feasible :
I. The company may issue 3,12,500 equity shares oft 10 per share.
2. The company may issue 1,56,250 equity shares of t 10 per share and 15,625 debentures
of t 100 denomination bearing 8% rate of interest.
3. The company may issue 1,56,250 equity shares of t 10 per share and 15,625 preference
shares of t 100 per share bearing 8% rate of dividend.
(i) If the company's earnings before interest and taxes are f 62,500, t 1,25,000,
t2,50,000, t 3,75,000 and t 6,25,000 what ~e the earnings per s~are under each of
three financial plans ? Assume a corporate mcome tax rate of 401/o.
(ii) Which alternative would you recommend and why ?
(iii) Determine the EBIT-EPS indifference points by formulae between financing Plan
1 and Plan 2 and Plan 1 and Plan 3.
[Ans. (i) EPS P lan 1 : '- · , · ' ·48 ' 0 ·72 ' 1.20 ; EPS Plan 2 : t 0.24, 0, 0.48, 0.96, 1.92;
"' 0 12 0 24 0
EPS Plan 3 : f (0.56), (0.32), 0. l 6, 0 -64, 1·60
(ii) Plan 2 recommende d.
• b tween plan 1 and 2 f 2,50,000 and between Plan 1 and Plan 3
(iii) Indifference pomt e
f4, 16,666.67] .
. . EPS Plant 2 it is assumed that the company shall set off theloss agamst other
Hint: For calculatmg ' ' · d forward The benefit off 25 000 has been given
points otherwise too the loss may be came ·. . ' ·
. ecting an annual earnmgs before mterest and tax (EBIT) of tS,00,000.
Ex. 9. (a) ~ c?mpan~ i~ e:cture has 12%. Debentures of t 15,00,000. The cost of equity or
The company m its capita s
If'""" ~ap ijal Str.uctqre
I
16.6 4
I
capitalisation rate is 16%. you are required h of the firm and over all cost o f capi·tal
to calculate t e va1ue
according to the Net Income Approach.
th . of debe ntur es and to use the proceeds
(b) If the firm decides to raise further t lO,OO
,OOO byl e 1}s: firm and over all capi talis
thereof to redeem equity shares, what shall ation rate
be the va ue O e
according to NI Approach.
[Ans. (i) t 35,00,000 ; 14.28%
(ii) ~ 37,50,000 ; 13.3 3%]
Ex. 10. XYZ Ltd. expects earnings before inter o db longs to
est and tax oft 6,00,_00 ~ta l eacco rdin grisk class of
l 0% You are required to calculate the value to the NOi
of the firm and coSt of equity capi fi ( .
appr~ach) if it employs 8% debt to the extent • t f
of 20%, 40% or 60% of the total man cia1
? 30,00,000. requ irem en °
[Ans. (a) 20% Deb t : Value of Firm f 60,0
0,000 ; Cos t of Equ ity 10.2 22%
(b) 40% Debt : Value of Firm f 60,00,00
0 ; Cos t of Equ ity 10.5 0%
(c) 60% Debt : Value of Firm f 60,00,000
; Cos t of Equity 10.857%)
Ex. 11. ABC Ltd. is expecting an annual earn
ings before interest and tax off 5,_00,000. The
has presently raised its entire funds requirem ~ompany
ent of f 30,00,000 by issue of equi ty shar
present equity capitalisation rate is 15%. The e capital. T?e
company is now contemplating to rede em
capital by introducing debt-financing . The a part of equity
firm bas two options to raise debt to the exte
60% of total requirement of funds. It is expe nt of 40% or
cted that for debt financing upto 40% the
will be 12% and equity capitalisation rate is rate of interest
expected to increase to 16%. How ever , if the
for 60% debt then interest will be 14% on entir com pany opts
e debt and equity capitalisation rate will incr
You are required to compute value of the ease to 18%.
firm and its overall cost of capi tal und er
[Ans. Option 1(0% Debt) Value of firm f diffe rent options.
33,33,333 ; Overall cost of capi tal 15%
Option 2 (40% Debt) Value of firm f 34,2
5,000 ; Overall cost of capi tal 14.5 98%
Option 3 (60% Debt) Value of firm f 31,7
7,778 ; Overall cost of capi tal 15.7 34 %]
Ex. 12. Companies X and Y are identical in
all respects including risk facto rs exce pt for
X having issued 10% debentures of f18 lakh debt/equity,
s while Y has issued only equi ty. Both the
20% before interest and taxe s on their total com pani es earn
assets of f30 lakhs.

II
Assuming a tax rate of 50% and capitalisation
rate of 15% for an all-e quit y com pany , com
valu e of companies X and Y usin g (i) net pute the
income approach and (ii) net oper atin g inco
me appr oach .
[Ans. Net Inco me App roac h f32, 00,0 00
and f20 ,00,0 00. Net oper atin g Inco me
f29, 00,0 00 and t20, 00,0 00] App roac h-
Ex. 13. The following is the data regardin
g two Com pani es 'X' and 'Y' belo ngin g
equi vale nt risk class : to the sam e

Com pany X Company Y

Num ber of ordinary shares
Market price per share 90,000 1,50,000
6% Debentures tl.20 Re.l. 00
Profit before interest 60,000
tl8,0 00 tl8,0 00
All profits after debe ntur e interest are distr
ibut ed as dividends.
You are requ ired to expl ain how unde r Mod
iglia ni & Mill er appr oach , an inve stor hold
shar es in Com pany 'X' will be bett er off ing l 0% of
in swit chin g his hold ing to Com pany 'Y'.
[An s. Pres ent Inco me = t144 0
Inco me afte r swit chin g hold ings =t16 56]
 capital Structure 16.65

Ex. 14. The values for two firms X and Y in accordance with the traditional theory are given below:
X y
Expected Operating Income (x) ~50,000 ~50,000
Total Cost of Debt (kd.=R) 10,000
0
Net Income 40,000
50,000
Cost of Equity (ke)
0.10 0.11
Market value of shares (S)
5,00,000 3,60,000
Market value of debt (D)
0 2,00,000
Total value of the finn (V+S+D)
5,00,000 5,60,000
Average cost of capital (ke)
0.10 0.09
Debt Equity Ratio
0 0.556

Compute the values for the firms X and Y as per the MM thesis. Assume that :
(i) Corporate income taxes do not exist, and
(ii) The equilibrium value of Ke is 12.5%
[Ans.Total value of each firm t4,00,000, Cost of Equity = 12.5%, 20%]
Ex. 15. The Evergreen Company has the choice for raising an additional sum of t 50 lakhs either
by the sale of 10% debentures or by issue of additional equity shares at t50 per share. The current
capitalisation structure of the company consists of 10 lakh ordinary shares of t 50 each and no debt.
At what level of earnings before interest and tax' (EBIT) after the new capital is acquired would earnings
per share (EPS) be the same whether new funds are raised either by issuing ordinary shares or by
issuing debentures ? Also determine the level of EBIT at which Uncommitted Earnings Per Share (UEPS)
would be the same, if sinking fund obligations amount to ts lakhs per year. Assume a 50% tax rate.
[Ans. (i) t55 lakhs (ii) tl 65 lakhs]
Ex. 16. AB limited provides you with following figures :-
r
Profit 3,00,000
Less Interest on Debentures @ 12% 60,000
2,40,000
Income- tax @ 50% 1,20,000
l ,20,000
Number of Equity Shares (~10 each) 40,000
E.P.S. (Earning per share) 3
Ruling price in market 30
PE ratio (Price/EPS) I0
The company has undistributed reserves of t6,00,000. The company needs t2,00,000 for expansion.
This amount will earn at the same rate as funds already employed. You are informed that a debt equity

ratio debt . higher than 35% will push the PIE ratio down to 8 and raise the interest rate on
debt+eqmty
additional amount borrowed to 14% You are required to ascertain the probable price of the share :

8
 arq
16.66
Capital Structure
(i) lf the additional funds are raised as debt ; and
(ii) If the amount is raised by issuing shares.
[Ans. (i) ~25.20 and (ii) t30]
Hint : New equity shares are issued at ruling market price, i.e.
t 30 per share.
Ex. 17. Firms X and Y identical are except that firm X is not
levered white Firm Y is levered. The
following data relate to them :

FirmX Firm Y

Assets
r r
5,00,000 5,00,000
Debt capital
0 2,50,000 (9% Int.)
Equity share capital
5,00,00 0 2,50,000
No. of shares
(50,000) (25,000)
Rate of Return on assets
20% 20%
Calculate EPS for both firms, assuming tax rate of 50%. Will
it be advantageous to firm Y to raise
the level of debt capital to 75% ?

[Ans. EPS : Firm X Re. 1.00 ; Firm Y t 1.55. Advantageous for firm Y to raise level of debt to
75% as EPS increases to t 2.65]

Ex. 18. A Comp any Ltd., has a share capital oft 1,00,000
dividend into shares oft 10 each. It
has major expan sion programme requiring an investment
of another t 50,000. The management is
consi derin g the following alternatives for raising this amou
nt :
(i) Issue of 5,000 shares of t 10 each.
(ii) Issue of 5,000, 12% preference shares oft 10 each.
(iii) Issue of 10% debentures of t 50,000.
The comp any's prese nt earning before interest and Tax (EBIT
) is t 30,000 p.a.
You are requi red to calculate the effect of each of the above
modes of financing on the earnings
per share (EPS ) presu ming .

(a) EBIT continues to be the same even after expansion ;

(b) EBIT increases by t 10,000.
(c) Assum e tax liability at 50%.
[Ans. (a) E.P.S . : Plan I Re. 1.00 ; Plan II Re. 0.90 ; Plan
III t 1.25.
(b) E.P.S. : Plan I t 1.33 ; Plan II t 1.40 ; Plan Ill t 1.75]
Ex. 19. Param ount Produ ces Ltd. wants to raise t 100 lakhs for
a diversification project. Current
estim ate of earnin gs befor e interest and taxes (EBIT) from
the new project is t 22 lakhs per annum.
Cost of debt will be 15% for amounts up to and including
t 40 lakhs, 16% for additional amounts
up to and includ ing t 50 lakhs and 18% for additional amou
nts above t 50 lakhs .
The equit y share s (face value t 10) of the company have
a current market value of~ 40. This is
expec ted to fall to t 32 if debts excee ding t 50 lakhs are
raised .
 Capita/Structure
16.67
The following options are und er cons1•d .
eration of the company :
Option
Equity Debt
I
50% 50%
11
60% 40%
III
40% 60%
Determine the earning per share (EPS) c10 .
• T t . r each option and state which option the company should
exercise. ax ra e app11cable to the company is SO%.
[Ans. EPS : Option It 5 76 . o ti II"" 5 .
. . · ' " .33 ; Option III t 5.04. First Option should be exercised]
P on
Ex. 20. Zemth Ltd. is considering three fimancia
. 1 p 1ans :
Fina11cial Plans Equity Debt Preference
A 100%
B 50% 50%
C 50% 50%
Total Funds to be Raised t 200 crore
Rate of Interest on Debt 12%
Corporate Tax Rate 35%
Dividend on Preference Shares 9%
Face Value of Equity Shares t l O each. These shares will be issued at a premium
of t 10 per share
Expected EBIT t 80 crore
Determine:
(i) EPS and Financial Break-Even Point for each plan.
(ii) Indifference points between Financial Plans A and B ; and A and C.
[Ans. (i) EPS : Plan I t 5.20 ; Plant II t 8.84 ; Plant I1I t 8.60. (ii) Indifference point between
plan A and B t 24 crore and between A and C t 27.69 crore.]
Ex. 21. The existing capital structure of ABC Ltd. is as follows :
s r
Equity Shares of~ I 00 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 of 12% and the tax on income is 50%. Company wants to raise t
25,00,000 for its expansion project for which it is considering following alternatives :
(i) Issue of 20,000 equity shares at a premium of t 25 per share.
(ii) Issue of 10% preference shares.
:nt (iii) Issue of 9% debentures.
m. Projected that the PIE ratios in the case of equity, preference and debenture financing would be 20,

its 17 and 16 respectively.

Which alternative would you consider to be the best ? Give reasons for your choice.
[Ans. EPS t 7.292 ; t 4.687 ; t 8.125 Expected Market Price Per Share t 145.84 ; t 79.68; t 130
is If objective is to increase EPS : Alternative Ill is the best. If objective is to increase MP : Alternative I is
better.]
 Capital Structure
16.68
Ex. 22. Skyline Software Ltd. has appointed you as its finance manager. The company wants to
implement a project for which t 30 lakhs is required to be raised from the market as a means of financing
the project. The following financing plans and options are at hand :
Plan A PlanB Plan C
(No. in thousands)

Option I :
Equity Shares 30 30 30
Option II :
Equity Shares 15 20 10
12% Preference Shares Nil lO 10
I 0% Non-Convertible Debentures 15 Nil 10
Assuming corporate tax to be 55% and the face value of all the shares and debentures to be t 100
eac~, calculated the indifference points and earning per share (EPS) for each of the financing plans.
Which plan should be accepted by the company ?
[Ans. Plan A Plan B Plan C
Indifference Point t 3,00,000 t 8,00,000 t 5,50,000
EPS t 4.50 t 12.00 t 8.25]

00000