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 ModiglianiMillers 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 sharps 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 debtequity 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 debtequity 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 debtequity 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
I_{1} = Interest under plan 1
1_{2} = Interest under plan 2
T = Tax Rate
PD = Preference dividend
8_{1} = Number of Equity shares of plan 1
8_{2} = 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
K_{e} = 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
K_{e} = Equity Capitalisation Rate
K = EBIT – I /VB 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 (K_{e}) = EBIT – I /VB 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