CapitalStructureandLeverage:

1. Difference between Financialand capital structure.

2. State the good and bad effects of using theleverage.

3. What does EPS indifference point show?

4. Afirmhas a DOL/DFLof 3.5 atQ units .whatdoes this indicate?

5. CalculatetheBEP(quantity) pointgiven thefollowing information.

Thefirmhas Rs1000000 in FC. The firm produces only one product and anticipates

selling each unit forRs25 with variablecostof Rs5 perunit.

6. Factors affecting capital structure.

7. OptimalCapitalStructure

8. EBIT-EPS analysis and effect of financial leverage.

9. Defineleverage. Explain its types.

10. What is trade-off theory of capital structure?

11. What is thepecking ordertheoryof capital structure?

12. What is thesignaling theory of capital structure?

13. Point out the theories of capitalstructure.

14. Computethefollowing Formula:

- ROE

- Equity

- Current Dividend per share (Do)

- Po

- Pre-taxincome(EBIT)

- Equalprofitsales

- Selling price perunit

- Variable costper unit

- EBIT(1-T)

- EBIT

- Incomestatement

- Equity-Debt:EPS=

- Equity-P.S:EPS=

- Equity-Debt-P.S:EPS=

- BEP

- Debt toequity ratio(D/E)

- Aftertaxcost of debt(Kdt)

- Expected stock price(Po)

- Ke

- WACC
 - Expected EPS when probability is given

- SDof EPS when probability is given

- Whenthere is noP.Scalculate the EPS indifference

- Whenthere is P.S calculate the EPS indifference

- Beta levered and beta unlevered

- Incomestatement showing various leverages

- Computation of DOL,DFL and combined leverage

- New EBIT

- %change in EBIT

SomePracticalProblems:

1. SDT Co. has a DOL of 2 times atits current production and sales level of 10000 units.

Theresulting operating profit is Rs1000.

a. If sales were expected to increaseby 20% fromthecurrent10000 unit sales

position, what would betheresulting operating profit?

b. At thecompany new sales position of 12000 units,what is thefirm’ snewDOL

figure?

2. SDT Ltd.has fixed operating costs of Rs10 million and a variablecost ratioof 0.65. The

firmhas Rs20 million,10% bank loan and Rs6 million,12% bond issueoutstanding.

Thefirmhas 1million shares of Rs5 (dividend) preferred stock and 2 million shares of

commonstock (Rs100 par value). SDT marginal tax rateis 30%. Salesareexpected to

be Rs80 million.

a. ComputetheSDT DOLat Rs 80 million sales levels.

b. ComputeSDT DFL atRs80 million sales levels.

c. If sales decline to Rs76 million,forecast SDT-EPS.

3. SDT Co.Ltd. Hasa currentcapital structure consisting of Rs250000 of 16% debt and

2000 shares of common stock. The firm pays taxesat therate of 40%.

a. Using EBIT values of Rs80000 and Rs120000,determinetheassociated EPS.

b. Using Rs80000 EBIT as a base,calculatetheDFL.

4. Intel computer producessmallcomputers thatsellforRs80000. Intel’ s FCare

Rs800000 and; VC=Rs40000. It produces 50 computers and sells each year. Intel’ s

assets (all equity financed) areRs1000000. Intel can changeits production process,

which needs additional Rs600000 toinvestment and Rs200000 toFixed operating

costs. This changewill(1) reduceVCper unitby Rs4000 and (2) increaseoutputby 20

units, but (3) thesales priceon all units will have to belowered toRs70000 to permit

increased outputalso. Inteluses nodebt,and its averagecost of capital is 15%.

a. Should Intelmakethechange?

b. Would Intel’ s DOL increaseordecreaseif itmade the change?

5. Suppose SDT Co. has decided infavor of a capitalrestricting that involves increasing

its existing Rs80 million in debttoRs125 million. Theinterestrate on thedebt is 9% and

is not expected tochange. Thefirmcurrently has 10 millionshares outstanding,and

theprice pershareis Rs45. If thereconstructing is expected to increasetheROEto

12%,what is theminimumlevelof EBIT thatmanagementmust beexpecting? Ignore

taxes.

6. Thecapitalstructure of theSDT Co. Ltd. Consist of an ordinary sharecapital of

Rs1000000 (sharesof Rs100 par value) and Rs1000000 of 10% debentures. Theunit

sales increased by 20% from100000 units to120000 units theselling price is Rs10 per
 unit, variablecostamount is Rs6 per unitand FC amount of Rs200000. Theincome tax

rate is assumed to be35%. Youarerequired tocalculate:

a. The% increasein EPS.

b. TheDFLand DOLat both units.

c. Commentonthebehaviorof DOLand DFLin relation oincreaseof production

from 100000 to120000 units.

7. Givethefollowing information fromS and D.

Firm S:BEP in units=25000;FC=Rs80000; Total revenueat BEP=Rs200000

Firm D: BEP in units=30000; FC=Rs120000; TotalrevenueatBEP=Rs240000

a. Which firmhas thehigheroperating leverage atany given level of sales?

Explain.

b. At whatlevel of sales in units,do both firms earn thesameoperating profit?

c. If both the company requirean after tax profit of Rs36000;what is thetarget

unitof sales required in each company? Assumecorporatetaxrateis 40%.

8. Acompany presentlycapitalized with Rs500000 consisting of 5000shares of

commonstock of Rs100 each. Additionalfinanceof Rs500000 is required foran

expansionprogram. Following possiblefinancing plansareunder consideration.

Plan1: Equity financing by issuing Rs100 pershare.

Plan2: 50% through equity of Rs 100 pershareand remaining through debt carrying

12% interest. Thecorporatetaxrateis 50%.

a. Calculatetheindifferencepointin EBIT between given plans.

b. Prepareincomestatement and calculateEPSunder eachplan.

9. Computethefollowing incomestatementof SDT co. of 2020.

INCOMESTATEMENT
Particulars Amount(Rs)

Sales 4500000

Less: variables costs (3000000)

ContributionMargin(CM) 1500000

Less: Fixed cost (500000)

EBIT/operatingprofit 1000000

Less :Interest (300000)

EBT 700000

Less: Tax@40% (280000)

NetIncome(NI) 420000

Less: Preferred dividend (20000)

NetIncometocommonstockholders 400000

No. of common stocks 10000

EPS 40

a. CalculatetheDOLin units,% and times.

b. CalculatetheDFLand DCL.

c. Find out theEPS of the companies if EBIT of thecompanies increaseor

decreaseby 25%.

d. If sales increaseby 20%,by what% would EBT or Net Income increase?

10. Firm S is trying to estimateits optimalcapitalstructure. Its currentcapitalstructure

consists of 40% debt and 60% equity; however,management believes thefirmshould

usemoredebt. The risk-freerateis 6%,themarket risk premium is 4%,and thefirm’ s

taxrate is 40%. Currently,its costof equity is 12%,which isdetermined on the basis of

theCAPM. What would beits estimated cost of equity if it weretochangeitscapital

structurefromits presentcapital structure to 50% debt and 50% equity?

11. SDT Co. has a capital structureconsisting of 20% debt and 80% equity. SDT debt

capacity hasan 8% yield tomaturity. Therisk-freerateis 5%, and the marketrisk

premiumis 6%. Using theCAPM,SDT estimatesthat its costof equity is currently

12.5%. Thecompany has a 40% tax rate.

a. What is SDTs currentWACC?

b. What is thecurrent betaon SDT common stock?

c. What would SDT betabeif thecompany had nodebtin its capital structure?

12. Firm S is considering following two alternative capitalstructures:

Capital structure1 Capitalstructure 2

Commonequity Rs1500000 Rs1000000

Debentures …………………. Rs500000

 TheBVPS of equity is Rs100. Thefirmpays 10% interestondebenture. Assuming the

firmis in50% corporate tax bracket; determinetheindifferencepointEBIT between

two capital structures and theEPS at theindifference point.

13. SDT is considering evaluating its nextyear’ s ROEunder differentleverageratios.

SDT totalassetsareRs21 million,and itstax rateis 40%. Thecompany is ableto

estimate nextyear’ s EBITfor three possiblestates of theeconomy:Rs6.3 million

with a 0.2 probability,Rs4.2 million with a 0.5 probability,and Rs1.05 millionwitha 0.3

probability. Calculate SDT expected ROE,SDand coefficientof variation foreach of

thefollowing leverageratioand interprettheresults.

Leverage(Debttototal assetsratio) InterestRate

0% -

10% 9%

60% 14%

14. TheSDTCo. and theDST Co. areidentical except for theirleverageratios and the

interest rateon debt. Eachhas Rs10 millionin assets,each earned Rs 2million before

interest and taxes in 2020 and each hasa 405 corporate tax rate. SDT however has a

leverage ratio(debt/totalassets) of 30% and pays 10% interestonits debt,while DST

has a 50% leverageratio,pays12% interest on debt.

a. Calculatetherateof return on equity foreach firm.

b. Observing that DST has ahigher return on equity, SDYT treasurer decides to

raise the leverageratiofrom 30 to60%. This will increase SDT interestrateondebt

to15%. Calculate the new rateorreturn on equity forSDT.

15. SDT Co. is entirely equity financed. At presentit has100000 shares outstanding.

Marketpriceper shareis Rs10. Therearethreepossiblestateof economy: Slump,

Normaland Boom. Operating profit under slump,normal, and boom economy will be

Rs75000,Rs125000 and Rs175000 respectively.

Required:

a. ComputeEPS and ROEif company is all equity financed.

b. Suppose company issuesRs500000 of new 10% debt and usestheproceed to

repurchaseand retirecommonstock,whatwillbeEPS and ROE?

16. SDT Co. sales areRs50000 and totalcost includesRs20000 FCand Rs20000 variable

cost.

Required:

a. DOL

b. % changein EBIT if sales increase or decrease by 20%.

17. SDT Co. has Rs100 millionin assets,which is financed with Rs20 million of debtand

Rs80 million in equity? If thefirm’ sbeta iscurrently 1.5 and its tax rateis 40%,what is

theunlevered beta?

18. Afirmhas DOLof 2 timesand DFLof 2.5 times. Its EBIT is currently Rs20000 and net

income is Rs9000. Whatis DTL?If sales increases by 10%,whatwillbeits new EBIT

and netincome?
19. SDT Co. is considering measuring the sensitivity of its operating incomeand net

income to change insales. If sales of the SDT increaseby 10%,EBITincreaseby25%

and in turn net income increases by 50%. What are its DOLand DFL?

20. SDT investments haveEBIT of Rs220000,fixed operating costof Rs130000,interest

expenses of Rs50000, and P.Dof Rs30000. Itpaystaxes attherateof 40%. What is its

DTL? If thefirmhas EPS of Rs5 and sales increases by 10%,whatwill beits newEPS?

21. Afirmhas thefollowing projections forEPSand the stock price atvariousdebtlevels:

Debt Ratio Projected EPS Projected stock price

20% Rs10 Rs120

30% 10.5 135

40% 11.25 130

50% 11 125

Assuming thatfirmuses only debt and equity,what is its optimalcapital structure?

22. Suppose afirm has unlevered betaof 0.8. If RF=5%, market risk premium=6%. What

will is its costof equity if unlevered?

BY.MR.SUNIL THAPA,

#SMARTBANKING TUITIONCENTER.