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Test Questions Of Capital Structure

1. Define capital structure.

2. What is meant by capital structure ?

3. List out the basic patterns of capital structure ?

4. What do you understand by capital structure ? What are the major determinants of capital

structure ?

5. Briefly explain the various theories of capital structure.

6. What are the characteristics of a balanced capital structure ?

7. Give a critical appraisal of the traditional approach and the Modigliani-Millers approach to

the problem of capital structure.

 

 

PROBLEMS AND SOLUTIONS

 

Problem 1. M /s Nagu  Ltd., has a share capital of $ 1,00,000 divided into 10,000 equity sharp-s of $ 10 each fully paid. It has a major expansion programme requiring an investment of another $ 50,000. The management is considering the following alternatives for raising this amount.

 

(a) Issue of 5, 000 Equity shares of $ 10 each

(b) Issue of 5,000 12% Preference shares of $ 10 each

(c) Issue of 10% Debentures of $ 50,000

 

The company’s present earnings before interest and taxes (EBIT) are $ 4 0,000 p.a. You are required to calculate the effect of each of the above modes of financing of the EPS (Earnings Per S hare) assuming ( i) EBI T continues to be the same even after expansion.

(ii) EBIT increases by $ 10,000. Assume tax rate at 50%.  

 

Solution :

(i) Computation of Earnings Per Share when EBIT is $ 40,000 p.a

         

Particulars        Present                                                Proposed

Capital structure                                Capital structure

All Equity             (i) All Equity     (ii) Equity + Pre    (iii) Equity + Debt

$                                $                          $                               $

EBIT                             40,000                  40,000             40,000                         40,000

Less : Interest                        –                                  –                       –                          5,000

PBT                             40,000                  40,000             40,000                        35,000

Less : Tax                           20,000                   20,000           20,000                       17,500

PAT                            20,000                  20,000             20,000                         17,500

Less : Pref. Dividend }           –                            –                   6,000                                –

Profit available for Equity

Shareholders                       20,000                     20,000          14,000                         17,500

Amount Available

for Equity shareholders      20,000                   20,000             14,000                         22,500

No. of Equity shares             10,000                    15,000          10,000                         10,000

EPS                                 2                           1.33                 1.40                           1.75

Dilution against

Initial EPS o f R s. 2                 –                        . 67                   .60                                  .25

 

The above solution shows that dilution of earning per share has been the least when the funds have been raised by issue of debentures.

 

(ii) Computation of Present and Projected Earnings Per Share when EBIT

Is $. 50,000 p.a. [ 40,000 + 10,000]

Present                                                       Proposed

Capital structure                                     Capital structure

All Equity               (i) All Equity        (ii) Equity + Pre    (iii) Equity + Debt

$                                 $                              $                                   $

EBIT                          40,000                    50,000                      50,000                        50,000

Less : Interest                        –                             –                              –                                5,000

PBT                                4 ,000                      50,000                  50,000                       45,000

Less : Tax                              20,000                     25,000                   25,000                        22,500

PAT                                20,000                      25,000                 25,000                           22,500

Less : Pref. Dividend                –                                –                          6,000                               –

Profit available for Equity }      20,000                  25,000                  19,000                         22,500

Share holders

No. o f Equity shares                 10,000                    15,000                10,000                        10,000

EPS                                   2                           1.67                       1.90                           2.25

Changes in EPS a s}

against initial of $  2.                  -2                             – .33                     – .10                         + .25

 

The above table indicates that EPS has gone up by $ 0.25 per share as against the present EPS when the funds are raised by issue of debentures. Hence, the use of debentures is the desirable capital structure for raising funds. Because, for the other two, the EPS goes down.

 

Problem 2. In considering the most desirable capital structure for a company, the following estimates of the cost of debt and equity capital (after tax) have been made at various levels of debt- equity mix.

Debt as percentage of

total capital employed

0

10

20

30

40

50

60

Cost of

Debt(%)

5.0

5.0

5.0

5.5

6.0

6.5

7.0

 

Cost of

Equity (%)

12.0

12.0

12.5

13.0

14.0

14.6

20.0

You are required to determine the optimal debt-equity mix for the company by calculating composite cost of capital. [B.Com adapted] .

 

Solution :

Statement showing the Company’s Composite Cost of Capital (after tax)

 

Debt                Cost of           Cost of

Percentage of total        Debt              Equity                        Composite Cost of Capital

capital employed

0                                    5.0                  12.0                     5 x 0 + 12 X 1 = 12.00

10                                5.0                   12.0                 5 x .10 + 12 X .90 = 11.30

20                                5.0                  12.5                 5 x .20 + 12.5 X .80 = 11.00

30                                5.5                   13.0                55 x .30 + 13 X .70 = 10.75

40                                6.0                   14.0                 6 x .40 + 14 X .60 = 10.80

50                                6.5                  16.0                6.5 x .50 + 16 X .50 = 11.25

60                                7.0                   20.0                 7.0 x .60 + 20 X .40 = 12.20

 

Problem 3. A new project is under consideration by Ram Ltd. which requires a capital

investment of $ 150 Lakhs. Interest on term loan is 12% and tax rate is 50%. If the debtequity

ratio insisted by the financing agencies is 2 :1, calculate the point of indifference for

the project.

 

Solution :

In case of project under consideration, the debt equity ratio insisted by the financing

agencies is 2 : 1.

Following are some possible alternatives :

(i) Raising the total capital by issue of equity shares.

(ii) Raising $ 100 lakhs by way of debt and $ 50 lakhs by way of issue of shares. Thus maintaining a debt-equity ratio of 2:1.

 

There are two possibilities available :

(i) Issuing the entire capital by way of issue of equity shares.

(ii) Mobilising $ 100 lakhs by way of debt and $ 50 lakhs by way of issue of shares. In this situation, they can maintain a debt-equity ratio of 2:1.

 

In the first case, the interest amount will be zero. But in the second case, it will be

$ 12 lakhs.

 

Computation of Point Indifference

 

( x – I 1 ) (1 – T) – PD / S1 = ( x – I 2 ) (1 – T) – PD Sl

 

(X ×  0) (1-.5) – 0  / 15 =(x – 12) x (1-.5) – 0 /5

 

( x ×  0.5) /15 = (x – 12) x .5/5

 

2.5x = 7.5x – 90

5x = 90

X = 90/5

= $ 18 lakhs

 

NOTE : EBIT at point of indifference is therefore $ 18 lakhs. If EBIT is $ 18 lakhs, the  earning on equity after tax will be 6% p.a. notwithstanding whether the capital is · financed fully by equity or by any other mix of equity and debt provided. The rate of interest on debt is 12%.

 

Where,             x = Point of Indifference or Break Even EBIT level

I1 = Interest under plan 1

12 = Interest under plan 2

T = Tax Rate

PD = Preference dividend

81 = Number of Equity shares of plan 1

82 = Number of Equity shares of plan 2.

 

Problem 4. (i) Murugappa & Co expects a net income of $ 80,000. It has 8% Debentures worth $ 2,00,000. The equity capitalisation rate of the company is 10%. Calculate the value of the firm and overall cost of capital rate according to the Net Income approach. (Ignoring income tax)

 

(ii) If Debenture debt is increased to $ 3,00, 000 what shall be the value of firm and the

overall cost of capital ?

 

Solution :

 

 

(i) Calculate the value of the firm :

V = S + B

V = Value of the firm

S = Market value of equity

B =NI /Ke  =  64,000 /10/100    i.e., 64,000 x 100 /10 =6,40 ,000

 

NOTE :

 

(i) Computation of NI (Net Income)

Net Income =

Less : Interest on 8% Debentures of $ 2,00,000         =

Amount available for Equity share holders

Ke : Equity capitalisation rate = 10%

Value the firm = $ 8,40,000 [6,40,000 + 2,00,000] [Value of Debenture 2,00,000]

 

(ii) Computation of overall capitalisation Rate :

Overall cost of capital (K) = EBITN

EBIT = Earnings before Interest and Tax

V = Value of the firm= 80,000 / 8,40,000 x 100= 9.52%

 

(iii) Computation of value of the firm when debentures raised to $ 3,00,000

Net income

Less : Interest on 8% Debentures of $ 3,00,000

Equity Capitalisation  Rate 10%

Market Value of Equity 56,000 x 10/100

Market Value of Debentures

Value of the Firm

Overall Cost of Cap1tal Rate = EBIT / V x 100

EBIT Earnings before interest and taxes

V :Value of the firm

i.e., 80,000

V  : 8,60,000

    $

80,000

 

16,000

64,000

 

 

 

 

 

 

 

 

 

 

80,000

24,000

56,000

 

56,000

5,60,000

3,00,000

8,60,000

 

 

Therefore, Overall Cost of Capital Rate = 80,000 /8,60,000  x  100 = 9.3%

 

Findings :

In the above computation there is increase in the debt financing and the value of the firm also increased so the overall cost of capital has decreased.

 

Problem 5. (i) SLM Ltd expects a net operating income of $ 2, 00,000. It has 6% Debentures worth $ 10,00,000. The overall capitalisation rate is 10%. Calculate the value of the firm and the equity capitalisation rate according to NOI  approach.

(ii) If the debenture debt is decreased to $ 7,50,000 what will be effect on the value of the firm and the equity capitalisation rate ?

 

Solution :

(i) Value of the firm : NOI approach

Here,   S = V – B

S = Value of Equity

V = Value of the Firm

B = Value of Debt.

First Step :

 

v = EBIT = 2, 00, 000 /10/100 = 2 00 000 x 100 /10 = 20, 00, 000

 

EBIT = Earning before interest and taxes 2,00,000

Ke = Equity capitalisation Rate 10%

B = Market value of Debenture : $ 10,00,000

 

Second Step :

S = V – B = 20,00,000 – 10,00,000 = 10,00,000

 

After arriving at the value of V & B, we can easily find the value of S

Ke = Equity Capitalisation Rate

K = EBIT – I /V-B  x 100 e

= 2,00,000 – 60,000  /20,00,000 – 10,00,000 x 100 = 14

 

(ii) If the debenture debt is increased to $ 7,50,000, the value of the firm remains unchanged at $. 10,00,000. The equity capitalisation rate will be as follows.

(1) Value of the firm

S = V – B

v = 20,00,000

B = 7,50,000

S = 12,50,000

 

(2) Equity Capitalisation Rate (Ke) = EBIT – I /V-B  x 100

 

2,00,000 – 45,000 x  100/ 20,00,000 – 7,50,000

= 12.4%

 

Problem 6. Two firms B and S are identical in all respects except the degree of leverage. Firm B has 6% of debt of $ 3.00 lakhs while firm S has no debt. Both the firms are earning an EBT of $ 1,20,000 each. The equity capitalisation rate is 10% and the corporate tax is 60%.

 

You are required to compute the market value of the two firms.

Solution :

Value of unlevered firm :                    (No debt content)

Formula :

Vu =Profit available for equity shareholders/  Equity Capitalisation Rate

 

= 1 , 20,000 – 72,000 / 10/100

= 48,000 X 100/10

Vu = $ 4,80,000

 

NOTE:

Profit available for equity shareholders

Earnings before tax                                          1,20,000

Less : Tax Rate (1,20,000 x 601100)                  72,000

Profit available for equity shareholders              48,000

 

Value of levered firm

Vi = Vu + Bt                                       Vi  =4,80,000 +3,00,000 x .6

Vi = Value of levered firm                      =5,60,000

Vu = Value of unlevered firm                        Vu =$ 4,80,000

B = Value of Debenture                     Vi =$ 5,60,000

t = Tax rate