Financing Decisions-Capital Structure – CA Inter FM Study Material is designed strictly as per the latest syllabus and exam pattern.

## Financing Decisions-Capital Structure – CA Inter FM Study Material

**Theory Questions**

Question 1.

What is Net Operating income theory of capital structure? Explain the assumptions on which the NOI theory is based. (4 Marks May 2012)

Answer:

Net Operating Income (NOI) Theory of Capital Structure: According to NOI approach, there is no relationship between the cost of capital and value of the firm i.e. the value of the firm is independent of the capital structure of the firm.

Assumptions:

- The corporate income taxes do not exist.
- Debt Equity mix is irrelevant for computation of market value of firm.
- With the increase in debt proportion, financial risk and expectations of shareholders increase.
- The overall cost of capital (K
_{0}) remains constant for all degrees of debt equity mix.

Question 2.

List the fundamental principles governing capital structure. (4 Mark. Nov. 2012, May 2016)

Answer:

Fundamental Principles Governing Capital Structure are:

(1) Financial leverage or Trading on Equity:

Debt is cheaper source of finance and interest is also allowed expense as per tax. When a firm raise funds through long-term fixed interest bearing debt and preference share capital along with equity share capital, EPS will increase if cost of fixed funds is lower than rate of return earned by firm. It is called as favourable leverage situation. If cost of fixed fund is higher than rate of return then leverage work adversely. Therefore, it needs caution to plan the capital structure of a firm.

(2) Growth and stability of sales:

Growth and stability of sales is most important factor to decide capital structure. Firm with stable sale can raise higher amount of debt because with stable revenue we can easily pay debt. Similarly, the rate of the growth in sales also provides confidence to management that they can easily pay interest and principal on time. With greater rate of growth of sales, firm can raise funds through debt. If sales of any firm is fluctuating then firm should not go with debt finance.

(3) Cost Principle:

As per cost principle, optimum capital structure is that debt equity mix at which cost of capital is lowest and market value of firm is highest.

(4) Risk Principle:

Due to commitment of fixed payment, debt is a risky source of finance and equity is non-risky source. Higher proportion of debt and accordingly higher risk is not recommended.

(5) Control Principle:

If we raise additional funds through issue of equity shares then control over company of existing shareholders will be diluted. Existing management control and ownership remains undisturbed with debt finance.

(6) Flexibility Principle:

Firm should arrange funds in an efficient manner so that we can increase or decrease company’s fund base according to requirement.

(7) Other Considerations:

Other factors such as nature of business, market situation, existing and future market scenario, government policies, timing of issue and competition in market etc. should also be considered.

Question 3.

What is Over capitalisation? State Its causes and consequences. (4 Marks Nov. 2013)

Answer:

Over capitalization: It is a situation where a firm has excess capital or funds are higher than requirement. In this situation assets are worth less than its issued share capital, and earnmgs are not sufficient to pay dividend and interest.

Causes of Over Capitalization.

- Raising higher amount through issue of shares or debentures than company needs.
- Raising higher amount of debt at higher rate than rate at which company can earn.
- Huge payment for the acquisition of fictitious assets like high payment is made to purchase goodwill etc.
- Provision for depreciation is not made properly.
- Payment of dividend with high rate.
- Estimation of earnings and capitalization was wrong.

Consequences of Over-Capitalisation

- Decrease in the rate of dividend and interest payments.
- Decrease in the market price of shares.
- Decrease in market value of firm.
- Firm may use window dressing.
- Reorganisation of company.
- Liquidation in worst scenario.

Question 4.

What do you mean by capital structure? State Its significance in financing decision. (4 Marks Nov. 2013)

Answer:

Capital structure:

Capital structure refers to the combination of funds from different sources of finance. Company can arrange funds through equity share capital, retained earnings, preference share capital and long term debts.

Significance:The primary objective of any firm is wealth maximisation. Value of any firm is calculated by capitalisation of it’s after tax earnings. Cost of capital is used as rate of capitalisation. Lower rate of cost of capital leads higher market value of firm and cost of capital is lowest at optimum capital structure.

So capital structure is relevant in maximizing value of the firm and minimizing overall cost of capital. To finance any investment or arrange any single rupee, firm has to take capital structure decision.

**Practical Problems**

**M. M. Approach:**

Question 1.

RES Ltd. Is an all equity financed company with a market value of ₹ 2500,000 and cost of equity K_{e} 21%.The company wants to buyback equity shares worth ₹ 5,00,000 by Issuing and raising 15% perpetual amount (Debt).

Rate of tax may be taken as 30%. After the capital restructuring and applying MM model with taxes.

You are required to calculate:

(a) Market value of RES Ltd.

(b) Cost of Equity K_{e}.

(c) Weighted average cost of capital and comment on it . (4 Marks May 2012)

Answer:

(a) Market Value (MV) of RES Ltd:

MV before restructuring (V_{UL}) = 25,00,000

MV after restructuring (V_{L}) = V_{UL} + Debt × Tax

(b) Cost of Equity:

K_{e} = K_{0} + (K_{0} – K_{d}) × \(\frac{D(1-t)}{E}\)

= 21 + (.21 – .15) × \(\frac{5,00,000(1-.30)}{21,50,000}\) = 21.97%

Here,

K_{d} = before tax cost of debt

K_{0} = K_{0} of unlevered firm

K_{0} of unlevered firm = K_{e} of unlevered firm = 21%

E = Value of Equity

E = Value of firm – Value of Debt

= 26,50,000 – 5,00,000 = 21,50,000

(c) Weighted average cost of capital:

WACC = K_{e}W_{e} + K_{d}W_{d}

= 21.97% × \(\frac{21,50,000}{26,50,000}\) + 10.50% × \(\frac{5,00,000}{26,50,000}\)

= 19.806%

Here,

K_{d} = I(1 – t) = 15% (1 – .30) = 10.50%

Comment: WACC after restructuring is lower than before restructuring. Hence, company should restructure the firm.

Question 2.

A’ Ltd. and ‘B’ Ltd. are Identical In every respect except capital structure. ‘A’ Ltd. does not use any debt in its capltalstructure whereas ‘B’ Ltd. employs 12% debentures amounting to ₹ 10,00,000. AssumIng that:

- AU assumptions of MM model are met; .
- Income tax rate Is 30%;
- EBIT is ₹ 2,50,000 and
- The equity capitalization rate of ‘A’ Ltd. Is 20%.

Calculate the value of both the companies and also find out Weighted Average Cost of Capital for both the companies. (5 Marks Nov. 2014)

Answer:

Calculation of value of ‘A’ Ltd and ‘B’ Ltd:

Value of ‘A’ Ltd. (Unlevered) = \(\frac{\text { EBIT }(1-\mathrm{t})}{\mathrm{K}_{\mathrm{e}}}\) = \(\frac{2,50,000(1-.30)}{.20}\) = 8,75,000

Value of ‘B’ Ltd. (Levered) = Market value of ‘A’ Ltd + Debt × Tax

= 8,75,000 + 10,00,000 × 30% = 11,75,000

Calculation of WACC of ‘A’Ltd and ‘B’ Ltd :

K_{0} of ‘A’ Ltd. = K_{e} of ‘A’ Ltd = 20% [In case of All equity company K_{0} = K_{e}]

K_{0} of ‘A’ Ltd. = \(\frac{\text { EBIT }(1-t)}{V}\) × 100

= \(\frac{2,50,000(1-.30)}{11,75,000}\) × 100 = 14.89%

Question 3.

PNR Limited and PXR Limited are Identical In every respect except capital structure. PNR limited does not employ debts in its capital structure whereas PXR Limited employs 12% Debentures amounting to 20,00,000.

The following additional Information are given to you:

(i) Income tax rate is 30%

(ii) EBIT is ₹ 5,00,000

(iii) The equity capitalization rate of PNR Limited Is 20% and

(iv) All assumptions of Modigliani. Miller Approach are met.

Calculate:

(i) Value of both the companies,

(ii) Weighted average cost of capital for both the companies. (8 Marks May 2017)

Answer:

Calculation of WACC of ‘PNR’ Ltd and ‘PXR’ Ltd:

Value of of ‘PNR’ Ltd. (Unlevered) = \(\frac{\text { EBIT }(1-t)}{\mathrm{K}_{\mathrm{e}}}\)

= \(\frac{5,00,000(1-.30)}{.20}\) = 17,50,000

Value of ‘PXR’ Ltd. (Levered) = Market value of ‘PNR’ Ltd + Debt × Tax

= 17,50,000 + 20,00,000 × 30% = 23,50,000

Calculation of WACC of ‘PNR’Ltd and ‘PXR’ Ltd:

K_{0} of ‘PNR’ Ltd = K_{e} of ‘PNR’ Ltd = 20% [In case of All equity company K_{0} = K_{e}]

K_{0} of ‘PXR’ Ltd. = \(\frac{\text { EBIT }(1-t)}{V}\) × 100

= \(\frac{5,00,000(1-.30)}{23,50,000}\) × 100 = 14.89%

Question 4.

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 it’s cost of capital is 20%. It’s earning before interest and tax (EBIT) are expected to remain constant in future. It’s entire earnings are distributed as dividend. Applicable tax rate is 30%.

You are required to calculate the impact on the following on account of the change in the capital structure as per MM Hypothesis:

(1) The market value of the company.

(2) It’s cost of capital, and

(3) It’s cost of equity. (5 Marks May 2018)

Answer:

(1) Market Value (MV) of Stopgo Ltd:

MVbeforerepurchase(V_{UL}) = 1,140 Lakhs

MV after repurchase (V_{L}) = V_{UL} + Debt × Tax

= 1,140 L + 200 L × 30% = 1,200 Lakhs

Impact on MV of firm = Increase by 60 Lakhs(1,200 L – 1,140 L)

(2) Weighted average cost of capital:

WACC before repurchase = 20%

WACC after repurchase = K_{e}W_{e} + K_{d}W_{d}

= 20.70% × \(\frac{1,000 \mathrm{~L}}{1,200 \mathrm{~L}} \frac{1,000 \mathrm{~L}}{1,200 \mathrm{~L}}\) + 10.50% × \(\frac{200 \mathrm{~L}}{1,200 \mathrm{~L}}\) = 19%

Impact on MV of firm = Decrease by 1% (20% – 19%)

Here,

K_{d} = I (1 – t) = 15% (1 – .30) = 10.50%

(3) Cost of Equity:

K_{e} before repurchase = 20%

K_{e} after repurchase = K_{0} + (K_{0} – K_{d}) × \(\frac{D(1-t)}{E}\)

= 20 + (.20 – .15) × \(\frac{200 \mathrm{~L}(1-.30)}{1,000 \mathrm{~L}}\) = 20.70%

Impact on MV of firm = Increase by 0.70% (20.70% – 20%)

Here,

K_{d} = before tax cost of debt

K_{0} = K_{0} of unlevered firm

K_{0} of unlevered firm = K_{e} of unlevered firm = 20%

E = Value of Equity

E = Value of firm – Value of Debt

= 1,200 L – 200 L = 1,000 L

Question 5.

The following data relate to two companies belonging to the same risk class:

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 capital for each company assuming no taxes as per M.M. Approach.

(b) Determine the total market value, Equity capitalization rate and weighted average cost of capital for each company assuming 40% taxes as per M.M. Approach. (10 Marks Nov. 2018)

Answer:

(a) Various calculation without tax:

Market Value of firms:

Market Value of B Ltd. (V_{UL}) = EBIT ÷ K_{e}

= ₹ 18,00,000 ÷ 18% = ₹ 1,00,00,000

Market Value of A Ltd. (V_{L}) = Value of unlevered = ₹ 1,00,00,000

Equity Capitalization Rate:

Equity Capitalization Rate (B Ltd.) = 18% (given in the question)

Equity Capitalization Rate (A Ltd.) = (EBIT – I) ÷ *E (Value of Equity)

= (₹ 18,00,000 – 1296 × ₹ 54,00,000) ÷ ₹ 46,00,000 = 25.04%

‘Value of Equity (E) of A Ltd. = Value of Firm – Debt

= ₹ 1,00,00,000 – ₹ 54,00,000 = ₹ 46,00,000

Weighted Average Cost of Capital:

Weighted Average Cost of Capital (B Ltd.) = K_{e} = K_{0} = 18%

Weighted Average Cost of Capital (A Ltd.) = EBIT ÷ V (Value of Firm)

= ₹ 18,00,000 = ₹1,00,00,000 = 18%

(b) Various calculation with tax:

Market Value of firms:

Market Value of B Ltd. (V_{UL}) = EBIT (1 – t) ÷ K_{e} or K_{0}

= ₹ 18,00,000 (1 – 0.40) ÷ 18% = ₹ 60,00,000

Market Value of A Ltd. (V_{L}) = Value of unlevered + Debt × Tax

= ₹ 60,00,000 + ₹ 54,00,000 × .4 = ₹ 81,60,000

Equity Capitalization Rate:

Equity Capitalization Rate (B Ltd.) = 18% (given in the question)

Equity Capitalization Rate (A Ltd.) = (EBIT – I) (I – t) ÷ *E (Value of Equity)

= (₹ 18,00,000 – 12% × ₹ 54,00,000) (1 -.4) ÷ ₹ 27,60,000

= 25.04%

*Value of Equity (E) of A Ltd. = Value of Firm – Debt

= ₹ 81,60,000 – ₹ 54,00,000 = ₹ 27,60,000

Weighted Average Cost of Capital:

Weighted Average Cost of Capital (B Ltd.) = K_{e} = K_{0} = 18%

Weighted Average Cost of Capital (A Ltd.) = EBIT(1 – t) ÷ V (Value of Firm)

= ₹ 18,00,000 (1 – 0.4) ÷ ₹ 81,60,000

= 13.24%

**Selection of Best Option (K _{0} based)**

Question 6.

RST Ltd. is expecting an EBIT of ₹ 4,00,000 for F.Y, 2015-16. Presently the company Is financed by equity share capital ₹ 20,00,000 with equity capitalization rate of 16%. The company is contemplating to redeem part of the capital by introducing debt financing. The company has two options to raise debt to the extent of 30% or 50% of the total fund. It is expected that for debt financing upto 30%, the rate of interest will be 10% and equity capitalization rate will increase to 17%. If the company opts for 50% debt, then the interest rate will be 12% and equity capitalization rate will be 20%.

You are required to compute value of the company; its overall cost of capital under different options and also state which is the best option. (8 Marks Nov. 2015)

Answer:

Statement of Value of Firm and Cost of Capital

Decision: Company should opt for 30% debt finance having higher Value of firm and lower K_{0}.

**Implied Return**

Question 7.

A Limited and B Limited are identical except for capital structures. A Ltd. has 60 per cent debt and 40 per cent equity, whereas B 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 X, own 3 per cent of the equity shares of A Ltd., determine his return if the Company has net operating income of ₹ 4,50,000 and the overall capitalisation rate of the company, K_{0} is 18 per cent.

(ii) Calculate the implied required rate of return on equity of A Ltd.

(b) B Ltd. has the same net operating income as A Ltd.

(i) Calculate the implied required equity return of B Ltd.

(ii) Analyse why does it differ from that of A Ltd. (10 Marks Jan. 2021)

Answer:

(a) Value of the A Ltd. = \(\frac{\mathrm{NOI}}{\mathrm{K}_{\mathrm{o}}}\) = \(\frac{4,50,000}{18 \%}\) = ₹ 25,00,000

Value of Shares of A Ltd. = 40% of ₹ 25,00,000 = ₹ 10,00,000

(i) Return of X on Shares on A Ltd.

(ii) Implied required rate of return on Equity

= \(\frac{3,30,000}{10,00,000}\) × 100 = 33%

(b) (i) Return on Shares on B Ltd.

Value of Shares of Beta Ltd. = 80% of ₹ 25,00,000

Implied required rate of return on Equity = \(\frac{4,10,000}{20,00,000}\) × 100 = 20.50%

(ii) It is lower than the A Ltd. because B Ltd. uses less debt in its capital structure. As the equity capitalisation is a linear function of the debt-to-equity ratio when we use the net operating income approach, the decline in required equity return offsets exactly the disadvantage of not employing so much in the way of “cheaper” debt funds.

**Selection of Financial Plan (EPS based)**

Question 8.

India Limited requires ₹ 50,00,000 for a New Plant. This Plant is expected to yield Earnings before Interest and Taxes of ₹ 10,00,000. While deciding about the Financial Plan, the Company considers the objective of maximizing Earnings per Share.

It has 3 alternatives to finance the Project: by raising Debt of ₹ 5,00,000 or ₹ 20,00,000 or ₹ 30,00,000 and the balance in each case, by issuing Equity Shares. The Company’s Share is currently selling at ₹ 150, but it is expected to decline to ₹ 125 in case the funds are borrowed in excess of ₹ 20,00,000.

The Funds can be borrowed at the rate of 9% upto ₹ 5,00,000, at 14% over ₹ 5,00,000 and upto ₹ 20,00,000 and at 19% over ₹ 20,00,000. The Tax rate applicable to the Company is 40%.

Which form of financing should the Company choose? Show EPS Amount upto two decimal points. (Marks 8 Nov, 2016)

Answer:

Statement of EPS

Decision: The earning per share is higher in alternative II Le. if the company finance the project by raising debt of ₹ 20,00,000 & issue equity shares of ₹ 30,00,000. Therefore, the company should choose this alternative to finance the project.

Question 9.

Y Limited requires ₹ 50,00,000 for a new project. This project is expected to yield earnings before interest and taxes of ₹ 10,00,000. While deciding about the financial plan, the company considers the objective of maximizing earnings per share. It has two alternatives to finance the project – by raising debt of ₹ 5,00,000 or ₹ 20,00,000 and the balance, in each case, by issuing equity shares. The company’s share is currently selling at ₹ 300, but is expected to decline to ₹ 250 in case the funds are borrowed in excess of ₹ 20,00,000. The funds can be borrowed at the rate of 12% upto K 5,00,000 and at 10% over ₹ 5,00,000. The tax rate applicable to the company is 25%.

Which form of financing should the company choose? (5 Marks Nov. 2018)

Answer:

Statement of EPS

Decision: The earning per share is higher in alternative II Le. if the company finance the project by raising debt of ₹ 20,00,000 & issue equity shares of ₹ 30,00,000. Therefore, the company should choose this alternative to finance the project.

Question 10.

RM Steels Limited requires ₹ 10,00,000 for the construction of new plant. It is considering three financial plans:

(1) The Company may issue 1,00,000 ordinary shares at ₹ 10 per share.

(2) The Company may issue 50,000 ordinary shares at ₹ 10 per share and 5,000 debentures of ₹ 100 denomination bearing 8% rate of interest.

(3) Company may issue 50,000 ordinary shares at ₹ 10 per share and 5,000 preference shares at ₹ 100 per share bearing a 8% rate of dividend.

If RM Steels Limited’s earnings before interest and taxes are ₹ 20,000, ₹ 40,000, ₹ 80,000, ₹ 1,20,000 and ₹ 2,00,000.

You are required to compute the earning per share under each of the three plans? Which alternative would you recommend for RM Steels and why? Tax rate is 50%. (10 Marks May 2019)

Answer:

1. Statement showing EPS with respect to various plans & different EBIT:

a. Equity Financing

b. Debt – Equity Mix

c. Preference Share – Equity Mix

*10,000 is the tax saving in case of loss’

**In case of cumulative preference shares, the company has to pay cumulative dividend to preference shareholders, when company earns sufficient profits.

2. Recommendation:

(a) If expected EBIT is less than₹ 80,000 : Equity Finance (Alternative 1)

(b) If expected EBIT is equal to ₹ 80,000 (Alternative 1 or 2) : Equity or Debt – Equity Mix

(c) If expected EBIT is more than ₹ 80,000 : Debt – Equity Mix (Alternative 2)

**Rate of Preference Dividend**

Question 11.

X Ltd. is considering the following two alternative financing plans:

The indifference point between the plans is 2,40,000. Corporate tax rate 30%. Calculate the rate of dividend on preference shares. (Marks 5 Nov. 2013)

Answer:

**Indifference point**

Question 12.

The management of Z Company Ltd. wants to raise its funds from market to meet out the financial demands of its long-term projects. The company has various combinations of proposals to raise its funds. You are given the following proposals of the company:

2. Cost of debt and preference shares is 10% each.

3. Tax rate 50%.

4. Equity shares of the face value of ₹ 10 each will be issued at a premium of ₹ 10 per share.

5. Total Investment to be raised ₹ 40,00,000.

6. Expected earnings before interest and tax ₹ 10,00,000,

From the above proposals the management wants to take advice from you for appropriate plan after computing the following:

(1) Earnings per share

(2) Financial break-even-point

(3) Compute the EBIT range among the plans for indifference. Also indicate if any of the plans dominate. (12 Marks May 2011)

Answer:

(1) Statement of EPS

Recommendation: Company should select debt option having highest EPS among different plans.

(2) Financial Break Even Point (EBIT equals to fixed financial cost):

Proposal P Financial B.E.P. = NoFixed Financial Cost = Zero

Proposal Q Financial B.E.P. = Interest on Debt = 2,00,000

Proposal R Financial B.E.P, = Gross Preference Dividend = \(\frac{\text { Preference Dividend }}{(1-\mathfrak{t})}\)

= \(\frac{2,00,000}{(1-0.50)}\)= 4,00,000

(3) Indifference Point:

Between Proposal P & Q:

Beiween Proposal Q & R: If No. of equity shares between two plans are same then, indifference point cant be calculate due to difference in fixed financial cost in Proposal Q and R. Proposal Q having lower financial fixed cost is always better than Proposal R having higher financial fixed cost.

Alternatively:

There is no indifference point between proposal ‘Q’ and proposal ‘R’

Analysis: It can be seen that financial proposal ‘Q’ dominates proposal ‘R’, since the financial break-even-point of the former is only ₹ 2,00,000 but in case of latter, it is ₹ 4,00,000.

Question 13.

Alpha Ltd. requires funds amounting to ₹ 80,00,000 for its new project. To raise the funds, the company has following two alternatives:

(1) To issue Equity Shares of 1100 each (at par) amounting to ₹ 60,00,000 and borrow the balance amount at the interest of 12% p.a.; or

(2) To issue Equity Shares of ₹ 100 each (at par) and 12% Debentures in equal proportion.

Find out the point of indifference between two modes of financing and state which option will be beneficial in different situations assuming tax rate 30%. (Marks 5 Nov. 2014)

Answer:

Calculation of Indifference between two modes of financing:

Course of action:

(a) If expected EBIT is less than ₹ 9,60,000 : Alternate 1

(b) If expected EBIT is equal to ₹ 9,60,000 : Alternate 1 or 2

(c) If expected EBIT is more than ₹ 9,60,000 : Alternate 2

Question 14.

The X Ltd. Is willing to raise funds for its new project which requires an investment of ₹ 84,00,000. The company has two options:

Option 1: To issue Equity Shares (₹ 10 each) only.

Option 2: To avail term loan at an interest rate of 12%. But in this case, as insisted by the financing agencies, the company will have to maintain a debt equity ratio of 2 : 1.

Find out the point of indifference for the project if corporate tax rate is 30%. (Marks 5 Nov. 2017)

Answer:

Calculation of point of Indifference:

\(\frac{(\mathrm{EBIT}-\mathrm{I})(1-\mathrm{T})}{\mathrm{N}_1}\) = \(\frac{(\mathrm{EBIT}-\mathrm{I})(1-\mathrm{T})}{\mathrm{N}_2}\)

\(\frac{(\text { EBIT }- \text { Nil })(1-0.30)}{8,40,000}\) = \(\frac{(\text { EBIT }-12 \% \text { of } 56,00,000)(1-0.30)}{2,80,000}\)

EBIT = ₹ 10,08,000

Calculation of amount of Debt and Equity in option 2:

Debt amount = 84,00,000 × 2/3 = 56,00,000

Equity amount = 84,00,000 × 1 /3 = 28,00,000

Question 15.

Sun Ltd. is considering two financing plans. Details of which are as under:

(a) Funds requirement is ₹ 100 Lakhs.

(b) Financial plans:

(c) Cost of debt is 12% p.a.

(d) Tax rate is 30%

(e) Equity shares ₹ 10 each, issued at a premium of ₹ 15 per share

(f) Expected earnings before interest and tax (EBIT) ₹ 40,00,000

You are required to compute:

(1) EPS in each of them plan

(2) The Financial break-even-point

(3) Indifference point between I and II (5 Marks May 2018)

Answer:

(1) Statement of EPS

Calculation of amount of number of Equity shares:

Under Plan I = 1,00,00,000 ÷ 25(10 + 15) = 4,00,000

Under Plan I = 25,00,000 ÷ 25(10 + 15) = 1,00,000

(2) Financial Break Even Point (EBIT equals to fixed financial cost):

Plan I Financial B.E.P. = No Fixed Financial Cost = Zero

Plan II Financial B.E.P. = Interest on Debt = 9,00,000

(3) Indifference Point:

\(\frac{(\mathrm{EBIT}-\mathrm{I})(1-\mathrm{T})}{\mathrm{N}_1}\) = \(\frac{(\mathrm{EBIT}-\mathrm{I})(1-\mathrm{T})}{\mathrm{N}_2}\)

\(\frac{(\text { EBIT }- \text { Nil })(1-0.30)}{4,00,000}\) = \(\frac{(\text { EBIT }-9,00,000)(1-0.30)}{1,00,000}\)

EBIT = ₹ 12,00,000

Question 16.

J Limited is considering three financing plans. The key information is as follows:

(a) Total investment to be raised ₹ 4,00,000.

(b) Plans showing the Financing proportion:

(c) Cost of debt is 10%

Cost of preference shares is 10%

(d) Tax rate 50%

(e) Equity shares of the face value of ₹ 10 each will be issued at a premium of ₹ 10 per share.

(J) Expected EBIT is ₹ 1,00,000.

You are required to compute the following for each plan:

(1) Earnings per share (EPS)

(2) Financial break-even-point

(3) Indifference point between the plans and indicate if any of the plans dominate. (10 Marks Nov. 2020)

Answer:

(1) Statement of EPS

(2) Financial Break Even Point (EBIT equals to fixed financial cost):

Proposal X Financial B.E.P. = No Fixed Financial Cost = Zero

Proposal Y Financial B.E.P. = Interest on Debt = 20,000

Proposal Z Financial B.E.P. = \(\frac{\text { Preference Dividend }}{(1-t)}\)

= \(\frac{20,000}{1-0.50}\) = 40,000

(3) Indifference Point:

Between Proposal X & Y

There is no indifference point between the financial plans Y and Z.

It can be seen that Financial Plan Y dominates Plan Z. Since, the financial break-even point of the former is only ₹ 20,000 but in case of latter it is ₹ 40,000.

**Important Questions**

Question 1.

X Ltd. and Y Ltd. are identical except that the former uses debt while the latter does not. Thus levered firm has issued 10% Debentures of ₹ 9,00,000. Both the firms earn EBIT of 20% on total assets of ₹ 15,00,000. Assuming tax rate is 50% and capitalization rate is 15% for an all equity firm.

(i) Compute the value of the two firms using NI approach.

(ii) Compute the value of the two firms using NOI approach.

(iii) Calculate the overall cost of capital, K_{0} for both the firms using NOI approach.

Answer:

(i) Calculation of Value of firms by NI Approach:

(ii) Values of the firm as per NOI Approach:

Value of unlevered firm (Y Ltd) = \(\frac{{EBIT}(1-\mathrm{t})}{\mathrm{K}_{\mathrm{0}}}\) = \(\frac{3,00,000(1-0.30)}{0.15}\)

Value of levered firm (X Ltd) = Value of unlevered firm + Debt × tax

= ₹ 10,00,000 + 9,00,000 × 50% = ₹ 14,50,000

This value of ₹ 14,50,000 can be bifurcated into Debt of ₹ 9,00,000 and Equity of ₹ 5,50,000.

(iii) Calculation of K_{0} under NOI Approach:

Y Ltd (K_{0}) = K_{e} = 15%

X Ltd (K_{0}) = K_{e}W_{e} + K_{d}W_{d}

= 19.1% × \(\frac{5,50,000}{14,50,000}\) + 5% × \(\frac{9,00,000}{14,50,000}\) = 10.34%

Working Notes:

Calculation of K_{e} of X Ltd:

K_{e} = \(\frac{\text { Earning for Equity }}{\text { Market value of Equity }}\) × 100 = \(\frac{(3,00,000-90,000)(1-0.50)}{5,50,000}\) × 100

= 19.10%

Question 2.

‘A’ Ltd. and ‘B’ Ltd. are identical in every respect except capital structure. ‘X Ltd. does not use any debt in its capital structure whereas ‘B’ Ltd. employs 12% debentures amounting to ₹ 10,00,000. Assuming that:

- All assumptions of MM model are met;
- Income tax rate is 30%;
- EBIT is ₹ 2,50,000 and
- The equity capitalization rate of ‘A’ Ltd. is 20%.

Calculate the value of both the companies and also find out Weighted Average Cost of Capital for both the companies.

Answer:

Calculation of value of ‘A’ Ltd. and ‘B’ Ltd

Value of ‘A’Ltd. (Unlevered) = \(\frac{\text { EBIT }(1-t)}{K_e}\) = \(\frac{2,50,000(1-.30)}{.20}\) = 8,75,000

Value of ‘B’ Ltd. (Levered) = Market value of ‘A’ Ltd. + Debt × Tax

= 8,75,000 + 10,00,000 × 30% = 11,75,000

Calculation of WACC of A’Ltd and B’Ltd:

K_{0} of ‘A’Ltd. = K_{e} of ‘A’Ltd. = 20%

K_{0} of ‘B’ Ltd. = \(\frac{\text { EBIT }(1-t)}{V}\) × 100 = \(\frac{2,50,000(1-.30)}{11,75,000}\) × 100 = 14.89%

Question 3.

RES Ltd. is an all equity financed company with a market value of ₹ 25,00,000and cost of equity K_{e} 21%. The company wants to buyback equity shares worth ₹ 5,00,000by issuing and raising 15% perpetual amount (Debt).

Rate of fax may be taken as 30%. After the capital restructuring and applying MM model with taxes.

You are required to calculate:

(a) Market value of RES Ltd.

(b) Cost of Equity K_{e}.

(c) Weighted average cost of capital and comment on it.

Answer:

(a) Market Value (MV) of RES Ltd:

MV before restructuring (V_{UL}) = 25,00,000

MV after restructuring (V_{L}) = V_{UL} + Debt × Tax

= 25,00,000 + 5,00,000 × 30% = 26,50,000

(b) Cost of Equity:

K_{e} = K_{0} + (K_{0} – K_{d}) × \(\frac{D(1-t)}{E}\)

= 2.1 + (.21 – .15) × \(\frac{5,00,000(1-.30)}{21,50,000}\) = 21.97%

Here,

K_{d} = before tax cost of debt

K_{0} = K_{0} of unlcvered firm

K_{0} of unlevered firm = K_{e} of unlevered firm = 21%

E = Value of Equity

E = 26,50,000 – 5,00,000 = 2 1,50,000

(c) Weighted average cost of capital:

WACC = K_{e}W_{e} + K_{d}W_{d}

= 21.97% × \(\frac{21,50,000}{26,50,000}\) + 10.50% × \(\frac{5,00,000}{26,50,000}\)

= 19.81%

K_{d} = I(1 – t) = 15%(1 – .30) = 10.50%

Comment: WACC after restructuring is lower than before restructuring. Hence, company should restructure the firm.

Question 4.

ABC Ltd. with EBIT of ₹ 3,00,000 is evaluating a number of possible capitals below. Which of the capital structure will you recommend, and why?

Answer:

Statement of K_{o} and Value of Firm

The capital structure (Plan I) having ₹ 3,00,000 of debt has the lowest cost of capital consequently the highest market value, should be accepted.

Question 5.

Alpha Limited and Beta Limited 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., determine your return if the company has net operating income of ₹ 3,60,000 and the overall capitalisation rate of the company, K_{o} is 18 per cent?

(ii) Calculate the implied required rate of return on equity?

(b) Beta Ltd. has the same net operating income as Alpha Ltd.

(i) Determine the implied required equity return of Beta Ltd.?

(ii) Analyse why does it differ from that of Alpha Ltd.?

Answer:

(a) Value of the Alpha Ltd. = \(\frac{\mathrm{NOI}}{\mathrm{K}_{\mathrm{o}}}\) = \(\frac{3,60,000}{18 \%}\) = ₹ 20,00,000

Value of Shares of Alpha Ltd. = 50% of ₹ 20,00,000 = ₹ 10,00,000

(i) Return on Shares on Alpha Ltd.

(ii) Implied required rate of return on Equity = \(\frac{2,80,000}{10,00,000}\) × 100 = 28%

(b) (i) Return on Shares on Beta Ltd.

Value of Shares of Beta Ltd. = 80% of ₹ 20,00,000 = ₹ 16,00,000

Implied required rate of return on Equity = \(\frac{3,28,000}{16,00,000}\) × 100 = 20.50%

(ii) It is lower than the Alpha Ltd. because Beta Ltd. uses less debt in its capital structure. As the equity capitalization is a linear function of the debt-to-equity ratio when we use the net operating income approach, the decline in required equity return offsets exactly the disadvantage of not employing so much in the way of “cheaper” debt funds.

Question 6.

Following data is available in respect of two companies having same business risk:

Capital employed = ₹ 2,00,000 .

EBIT = ₹ 30,000

K_{e} = 12.5%

Investor is holding 15% shares in levered company.

Calculate increase in annual earnings of investor if he switches his holding from levered to unlevered company.

Answer:

1. Calculation of Value of firms:

Value of Levered company is more than that of unlevered company therefore investor will sell his shares in levered company and buy shares in unlevered company. To maintain the level of risk he will borrow proportionate amount and invest that amount also in shares of unlevered company.

2. Investment & Borrowings:

3. Change in Return:

Question 7.

Following data Is available in respect of two companies having same business risk:

Capital employed = ₹ 2,00,000

EBIT = ₹ 30,000

Investor is holding 15% shares in Unlevered company.

Calculate increase in annual earnings of investor if he switches his holding from unlevered to levered company.

Answer:

1. Calculation of Value of firms:

Value of Unlevered company is more than that of Levered company therefore investor will sell his shares in unlevered company and buy shares in levered company. Market value of Debt and Equity of Levered company are in the ratio of ₹ 1,00,000: ₹ 1,00,000, i.e., 1:1. To maintain the level of risk he will lend proportionate amount (50%) and invest balance amount (50%) in shares of Levered company.

2. Investment:

3. Change in Return:

Question 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 projects 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% up to ₹ 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%.

Which form of financing should the company choose?

Answer:

Statement of EPS

Decision: The earning per share is higher in alternative II i.e. if the company finance the project by raising debt of ₹ 10,00,000 & issue equity shares of ₹ 15,00,000. Therefore, the company should choose this alternative to finance the project.

Question 9.

A Company earns a profit of ₹ 3,00,000 per annum after meeting its interest liability of ₹ 1,20,000 on 12% debentures. The Tax rate is 50%. The number of Equity Shares of ₹ 10 each are 80,000 and the retained earnings amount to ₹ 12,00,000. The company proposes to take up an expansion scheme for which a sum of ₹ 4,00,000 is required.

It is anticipated that after expansion, the company will be able to achieve the same return on investment as at present. The funds required for expansion can be raised either through debt at die 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.

Answer:

(i) Statement of EPS

Working notes:

1. Calculation of capital employed before expansion plan:

Equity share capital : ₹ 8,00,000

Retained earnings : ₹ 12,00,000

Debentures (1,20,000/12%) : ₹ 10,00,000

Total capital employed : ₹ 30,00,000

2. Earnings before the payment of Interest and tax (EBIT):

Profit before tax : ₹ 3,00,000

Interest : ₹ 1,20,000

EBIT : ₹ 4,20,000

3. Return on Capital Employed (ROCE):

ROCE = \(\frac{\text { EBIT }}{\text { Capital Employed }}\) × 100 = \(\frac{4,20,000}{30,00,000}\) × 100 = 14%

4. After expansion capital employed = ₹ 34,00,000 (₹ 30,00,000 + ₹ 4,00,000)

(ii) Advise to the company: Since EPS is greater in the case when company arranges additional funds as debt. Therefore, the company should finance the expansion scheme by raising debt.

Question 10.

The following data are presented in respect of Quality Automation Ltd.:

The company is planning to start a new project requiring a total capital outlay of ₹ 40,00,000. You are informed that a debt equity ratio (D/D+E) higher than 35% push the Ke up to 12.5% means reduce PE ratio to 8 and rises the interest rate on additional amount borrowed at 14%.

Find out the probable price of share if:

(1) The additional funds are raised as a loan.

(2) The amount is raised by issuing equity shares.

(Note: Retained earnings of the company is 11.2 crore)

Answer:

In this question EBIT after proposed extension is not given. Therefore, we can assume that existing return on capital employed will be maintained.

Statement of Market Value Per Share (MPS)

Working notes:

1. Calculation of capital employed before expansion plan:

Equity share capital (8,00,000 shares × ₹ 10) : ₹ 80,00,000

Retained earnings : ₹ 1,20,00,000

Debentures (12,00,000/12%) : ₹ 1,00,00,000

Total capital employed : ₹ 3,00,00,000

2. Return on Capital Employed (ROCE):

ROCE = \(\frac{\text { EBIT }}{\text { Capital Employed }}\) × 100 = \(\frac{52,00,000}{30,00,000}\) × 100 = 17%

3. Debt Equity Ratio if ₹ 40,00,000 is raised as Debt:

= \(\frac{1,40,00,000(1,00,00,000+40,00,000)}{3,40,00,000(3,00,00,000+40,00,000)}\) × 100 = 41.18%

As the debt equity ratio is more than 35% the P/E ratio will be brought down to 8 in Plan 1

4. Debt Equity Ratio if ₹ 40,00,000 is raised as Equity:

= \(\frac{1,00,00,000}{3,40,00,000}\) × 100 = 29.41%

As the debt equity ratio is less than 3596 the P/E ratio in this case will remain at 10 times in Plan 2.

5. Number of Equity Shares to be issued in Plan 2 = \(\frac{40,00,000}{25}\) = 1,60,000 shares

Decision: Though loan option has higher EPS but equity option has higher MPS therefore company should raise additional fund through equity option.

Question 11.

Yoyo Limited 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 three 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) Analyse which alternative do you prefer? Compute how much would EBIT need to increase before the next alternative would be best?

Answer:

(a) Statement of EPS

(b) For the present EBIT level, equity share is clearly preferable. EBIT would need to increase by ₹ 23,76,000 – ₹ 15,00,000 = ₹ 8,76,000 before an indifference point with debt is reached. One would want to be comfortably above this indifference point before a strong case for debt should be made. The lower the probability that actual EBIT will fall below the indifference point, the stronger the case that can be made for debt, all other things remain the same.

Working Note:

Indifference Point between Equity and Debt plan:

\(\frac{(\mathrm{EBIT}-\mathrm{I})(1-\mathrm{T})}{\mathrm{N}_{\mathrm{E}}}\) = \(\frac{(\mathrm{EBIT}-\mathrm{I})(1-\mathrm{T})}{\mathrm{N}_{\mathrm{D}}}\)

\(\frac{(\text { EBIT }-3,60,000)(1-0.40)}{10,50,000}\) = \(\frac{(\text { EBIT }-8,40,000)(1-0.40)}{8,00,000}\)

EBIT = ₹ 23,76,000

Question 12.

Ganapati Limited is considering three financing plans. The key information is as follows:

(a) Total investment to be raised ₹ 2,00,000.

(b) Financing proportion of Plans:

(c) Cost of debt is 8%

Cost of preference shores is 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 EBIT is ₹ 80,000.

You ate required to determine for each plan:

(1) Earnings per share

(2) Financial break-even-point

(3) Indicate if any of the plans dominate and compute the EBIT range among the plans for indifference.

Answer:

(1) Statement of EPS

(2) Financial Break Even Point (EBIT equals to fixed financial cost):

Proposal A Financial B.E.P. = No Fixed Financial Cost = Zero

Proposal B Financial B.E.P. = Interest on Debt = 8,000

Proposal C Financial B.E.P. = \(\frac{\text { Preference Dividend }}{(1-\mathrm{t})}\)

= \(\frac{8,000}{1-0.50}\) = 16,000

(3) Indifference Point:

Between Proposal A & B:

There is no indifference point between the financial plans B and C.

It can be seen that Financial Plan B dominates Plan C. Since, the financial break-even point of the former is only ₹ 8,000 but in case of latter it is ₹ 16,000.

Question 13.

RM Steels Limited requires ₹ 10,00,000 for the construction of new plant. It is considering three financial plans:

- The Company may issue 1,00,000 ordinary shares at ₹ 10 per share.
- The Company may issue 50,000 ordinary shares at ₹ 10 per share and 5,000 debentures of ₹ 100 denomination bearing 8% rate of interest.
- The Company may issue 50,000 ordinary shares at ₹ 10 per share and 5,000 preference shares at ₹ 100 per share bearing a 8% rate of dividend.

If RM Steels Limited’s earnings before interest and taxes are ₹ 20,000, ₹ 40,000, ₹ 80,000, ₹ 1,20,000 and ₹ 2,00,000.

You are required to compute the earning per share under each of the three plans? Which alternative would you recommend for RM Steels and why? Tax rate is 50%.

Answer:

1. Statement showing EPS with respect to various plans & different EBIT:

a. Equity Financing

b. Debt – Equity Mix

c. Preference Share – Equity Mix

*10,000 is the tax saving in case of loss.

** In case of cumulative preference shares, the company has to pay cumulative dividend to preference shareholders, when company earns sufficient profits.

2. Recommendation:

(a) If expected EBIT is less than ₹ 80,000 : Equity Finance (Alternative 1)

(b) If expected EBIT is equal to ₹ 80,000 : Equity or Debt – Equity Mix (Alternative 1 or 2)

(c) If expected EBIT is more than ₹ 80,000 : Debt – Equity Mix (Alternative 2)