CA KOUSHIK MUKESH

5 Financing Decision – Capital structure

Question 1 (RTP Nov 23)

1. Prakash Limited provides you the following information:

(₹)

Profit (EBIT) 3,00,000

Less: Interest on Debenture @ 10% (50,000)

EBT 2,50,000

Less: Income Tax @ 50% (1,25,000)

1,25,000

No. of Equity Shares (₹ 10 each) 25,000

Earnings per share (EPS) 5

Price /EPS (PE) Ratio 10

The company has reserves and surplus of ₹ 7,50,000 and required ₹ 5,00,000

further for modernisation. Return on Capital Employed (ROCE) is constant.

Debt (Debt/ Debt + Equity) Ratio higher than 40% will bring the P/E Ratio

down to 8 and increase the interest rate on additional debts to 12%. You

are required to ASCERTAIN the probable price of the share.

(i) If the additional capital is raised as debt; and

(ii) If the amount is raised by issuing equity shares at ruling market price
Answer:
Plan – I Plan – II
If ₹ 5,00,000 If ₹ 5,00,000 is
Particulars
is raised as raised by issuing
debt (₹) equity shares (₹)
Earnings Before Interest and Tax (EBIT)
{20% of new capital i.e., 20% of (₹15,00,000 4,00,000 4,00,000
+ ₹ 5,00,000)} (Refer working note1)

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Less: Interest on old debentures (10% of (50,000) (50,000)

₹5,00,000)
Less: Interest on new debt (12% of 2,90,000 3,50,000
₹5,00,000) Earnings Before Tax (EBT)
Less: Tax @ 50% (1,45,000) (1,75,000)
Earnings for equity shareholders (EAT) 1,45,000 1,75,000
No. of Equity Shares (refer working note 2) 25,000 35,000
Earnings per Share (EPS) ₹ 5.80 ₹ 5.00
Price/ Earnings (P/E) Ratio (refer working 8 10
note 3)
Probable Price Per Share (PE Ratio × EPS) ₹ 46.40 ₹ 50

Working Notes:

1. Calculation of existing Return of Capital Employed (ROCE):

(₹)
Equity Share capital (25,000 shares × ₹10) 2,50,000
 100  5,00,000
 50, 000  
10% Debentures  10 
Reserves and Surplus 7,50,000
Total Capital Employed 15,00,000
Earnings before interest and tax (EBIT) (given) 3,00,000
3, 00, 000 20%
ROCE = 15, 00, 000 × 100

2. Number of Equity Shares to be issued in Plan-II:

5, 00, 000
= 50 = 10,000 Shares

Thus, after the issue total number of shares = 25,000+ 10,000 = 35,000 shares

3. Debt/Equity Ratio if ₹ 5,00,000 is raised as debt:

10, 00, 000
= 20, 00, 000 × 100 = 50%

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As the debt equity ratio is more than 40% the P/E ratio will be brought down to

8 in Plan-I

Question 2 (RTP May 23)

Current Capital Structure of XYZ Ltd is as follows:

Equity Share Capital of 7 lakh shares of face value ₹ 20 each

Reserves of ₹ 10,00,000

9% bonds of ₹ 3,00,00,000

11% preference capital: 3,00,000 shares of face value ₹ 50 each

Additional Funds required for XYZ Ltd are ₹ 5,00,00,000.

XYZ Ltd is evaluating the following alternatives:

I. Proposed alternative I: Raise the funds via 25% equity capital and 75%

debt at 10%. PE ratio in such scenario would be 12.

II. Proposed alternative II: Raise the funds via 50% equity capital and

rest from 12% Preference capital .PE ratio in such scenario would be

11.

Any new equity capital would be issued at a face value of ₹ 20 each. Any

new preferential capital would be issued at a face value of ₹ 20 each. Tax

rate is 34%

DETERMINE the indifference point under both the alternatives.

Answer:
Current Capital Structure
Equity Share Capital 20 × 7 Lakhs 1,40,00,000
Reserves 10,00,000
9% Bonds 3,00,00,000
11% Preference Share Capital 50 × 3 Lakhs 1,50,00,000
Total Capital Employed 6,00,00,000

Proposed Capital Structure

Capital Working Proposal I Proposal II

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Capital to be raised ₹ 5,00,00,000 ₹ 5,00,00,000

Equity 5,00,00,000 × ₹ 1,25,00,000 ---
25%
5,00,00,000 × --- ₹ 2,50,00,000
50%
Debt @ 10% 5,00,00,000 × ₹ 3,75,00,000 ---
75%
Preference Shares @ 5,00,00,000 × --- ₹ 2,50,00,000
12% 50%

Combined Capital Amount Amount

Proposal I Proposal II
Equity 2,65,00,000 3,90,00,000
Reserves 10,00,000 10,00,000
9% Bond 3,00,00,000 3,00,00,000
10% Debt 3,75,00,000 ---
11% Preference Shares 1,50,00,000 1,50,00,000
12% Preference Shares 2,50,00,000
11,00,00,000 11,00,00,000

Interest for Proposal I = ₹ 3,00,00,000 x 9% + ₹ 3,75,00,000 x 10%

= ₹ 27,00,000 + ₹ 37,50,000
= ₹ 64,50,000
Preference Dividend for Proposal I = ₹ 1,50,00,000 x 11% = ₹ 16,50,000

Interest for Proposal II = ₹ 3,00,00,000 x 9% = ₹ 27,00,000

Preference Dividend for Proposal II = ₹ 1,50,00,000 x 11% + ₹ 2,50,00,000 x 12%

= ₹ 16,50,000 + ₹ 30,00,000 = ₹ 46,50,000

Let the indifference point be ₹ X

For Proposal I,

 X  64, 50, 000  0.66  16, 50, 000

EPS = 13, 25, 000 - - - - - - - - (1)

For Proposal II,

 X  27, 00, 000  0.66  46, 50, 000

EPS = 13, 25, 000 - - - - - - - - (2)
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Equating (1) and (2),

 X  64, 50, 000  0.66  16, 50, 000  X  27, 00, 000  0.66  46, 50, 000
EPS = 13, 25, 000 = 13, 25, 000

0.66X  59, 07, 000 0.66X  64, 32, 000

53 = 78

₹ 51.48X – ₹ 46,07,46,000 = ₹ 37.98X - ₹34,08,96,000

₹ 16.5X = ₹ 11,98,50,000

Indifference Point = X = ₹ 72,63,636.36

Question 3 (RTP Nov 22)

ABC Limited provides you the following information:
(₹)
Profit (EBIT) 2,80,000
Less: Interest on Debt @10% 40,000
EBT 2,40,000
Less: Income Tax @ 50% 1,20,000
1,20,000
No. of Equity Shares (₹ 10 each) 30,000
Earnings per share (EPS) 4
Price / EPS (P/E) Ratio 10
Ruling Market price per share 40

The company has undistributed reserves of ₹ 7,00,000 and needs ₹ 4,00,000

further for expansion. This investment is expected to earn the same rate as

funds already invested. You are informed that a debt equity (debt/ debt

+equity) ratio higher than 32% will push the P/E ratio down to 8 and raise

the interest rate on additional borrowings (debentures) to 12%. You are

required to ASCERTAIN the probable price of the share.

(i) If the additional funds are raised as debt; and

(ii) If the amount is raised by issuing equity shares at ruling market price

of ₹ 40 per share.

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Answer:

Particulars Plan – I Plan – II

If ₹ 4,00,000 If ₹ 4,00,000 is
is raised as raised by issuing
debt (₹) equity shares (₹)
Earnings Before Interest and Tax (EBIT) 3,60,000 3,60,000
{20% on (₹14,00,000 + ₹ 4,00,000)}
Less: Interest on old debentures (10% of 40,000 40,000
₹4,00,000)
3,20,000 3,20,000
Less: Interest on New Debt 12% on 48,000 ---
₹4,00,000
Earnings Before Tax (after Interest) 2,72,000 3,20,000
Less: Tax @ 50% 1,36,000 1,60,000
Earnings for equity shareholders (EAIT) 1,36,000 1,60,000
No. of Equity Shares (in numbers) 30,000 40,000
Earnings per Share (EPS) ₹4.53 ₹ 4.00
Price / Earnings Ratio 8 10
Probable Price Per Share ₹ 36.24 ₹ 40
(8 × 4.53) (10 × 4)

Working Notes:
(₹)
1. Calculation of Present Rate of Earnings
Equity Share capital (30,000 x ₹ 10) 3,00,000
 100  4,00,000
 40, 000  
10% Debentures  10 

Reserves (given) 7,00,000

14,00,000
Earnings before interest and tax (EBIT) given 2,80,000
 2, 80, 000  20%
 14, 00, 000  100 
Rate of Present Earnings =  

2. Number of Equity Shares to be issued in Plan 10,000

 4, 00, 000 
 
 40 

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Thus, after the issue total number of shares 30,000 + 10,000 =

40,000

3. Debt/Equity Ratio if ₹ 4,00,000 is raised as debt:  8, 00, 000 

 18, 00, 000  100 
 

As the debt equity ratio is more than 32% the P/E ratio shall be 8 in plan (i) =

44.44%

Question 4 (RTP Nov 20)

Xylo Ltd. is considering two alternative financing plans as follows:

Particulars Plan – A (₹) Plan – B (₹)

Equity shares of ₹ 10 each 8,00,000 8,00,000
Preference Shares of ₹ 100 each --- 4,00,000
12% Debentures 4,00,000 ---
12,00,000 12,00,000

The indifference point between the plans is ₹ 4,80,000. Corporate tax rate

is 30%. CALCULATE the rate of dividend on preference shares.

Answer:

Computation of Rate of Preference Dividend

 EBIT – Interest  1 – t  EBIT 1 – t   Preference Dividend

No. of Equity Shares  N1 No. of Equity Shares  N2
=

 4, 80, 000  48, 000  1  0.30 4, 80, 000 1  0.30  Preference Dividend
80, 00, 000 Shares = 80, 00, 000 Shares

₹ 3, 02, 400 = 3,36, 000 ⎼ Preference Dividend

Preference Dividend = ₹ 3,36,000 – ₹ 3,02,400 = ₹ 33,600

Preference Dividend 33, 600
Rate of Dividend = Preference Share Capital ×100 = 4, 00, 000 ×100 = 8.4%.

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Question 5 (RTP May 20)
CALCULATE the level of earnings before interest and tax (EBIT) at which

the EPS indifference point between the following financing alternatives will

occur.

1. Equity share capital of ₹60,00,000 and 12% debentures of ₹40,00,000.

(Or)

2. Equity share capital of ₹40,00,000, 14% preference share capital of

₹20,00,000 and 12% debentures of ₹40,00,000.

Assume the corporate tax rate is 35% and par value of equity share is ₹100

in each case.

Answer:

Computation of level of earnings before interest and tax (EBIT)

In case, alternative (i) is accepted, then the EPS of the firm would be:

 EBIT  Interest 1  TaxRate 

EPS Alternative (i) = No. of Equity Shares

 EBIT  0.12  40, 00, 0001  0.35

= 60, 000 Shares

In case, alternative (ii) is accepted, then the EPS of the firm would be:

 EBIT  0.12  40, 00, 0001  0.35  0.14  20, 00, 000
EPS Alternative (ii) = 40, 000 Shares

In order to determine the indifference level of EBIT, the EPS under the two

alternative plans should be equated as follows:

 EBIT  0.12  40, 00, 0001  0.35  EBIT  0.12  40, 00, 0001  0.35  0.14  20, 00, 000
60, 000 Shares = 40, 000 Shares

0.65 EBIT  3, 12, 000 0.65 EBIT  5, 92, 000

Or 3 = 2
Or 1.30 EBIT ⎼ ₹6,24,000 = 1.95 EBIT ⎼ ₹17,76,000
Or (1.95 ⎼ 1.30) EBIT = ₹17,76,000 - ₹6,24,000 = ₹11,52,000

11, 52, 000

Or EBIT = 0.65
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Or EBIT = ₹17,72,308

Question 6 (RTP Nov 19)

The management of RT 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:

Proposal Equity shares (%) Debts (%) Preference Shares (%)

P 100 --- ---
Q 50 50 ---
R 20 --- 50
Cost of debt and preference shares is 12% each.

Tax rate –40%

Equity shares of the face value of ₹10 each will be issued at a premium of

₹10 per share.

Total investment to be raised ₹8,00,00,000.

Expected earnings before interest and tax ₹3,60,00,000.

From the above proposals the management wants to take advice from you for

appropriate plan after computing the following:

 Earnings per share

 Financial break-even-point

COMPUTE the EBIT range among the plans for indifference.

Answer:

Computation of Earnings per Share (EPS)

Plans P (₹) Q (₹) R (₹)

Earnings before interest & tax 3,60,00,000 3,60,00,000 3,60,00,000

(EBIT)

Less: Interest charges --- (48,00,000) ---

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Earnings before tax (EBT) 3,60,00,000 3,12,00,000 3,60,00,000

Less: Tax @ 40% (1,44,00,000) (1,24,80,000) (1,44,00,000)

Earnings after tax (EAT) 2,16,00,000 1,87,20,000 2,16,00,000

Less: Preference share dividend --- --- (48,00,000)

Earnings available for equity 2,16,00,000 1,87,20,000 1,68,00,000

shareholders

No. of equity shares 40,00,000 20,00,000 20,00,000

E.P.S 5.40 9.36 8.40

1. Computation of Financial Break-even Points

Proposal ‘P’ = 0

Proposal ‘Q’ = ₹48,00,000 (Interest charges)

Proposal ‘R’ = Earnings required for payment of preference share dividend i.e.
48, 00, 000
= 0.6 ₹80,00,000

2. Computation of Indifference Point between the Proposals

Combination of Proposals

(a) Indifference point where EBIT of proposal “P” and proposal ‘Q’ is equal

EBIT 1  0.4   EBIT  48, 00, 0001  0.4 

40, 00, 000 Shares = 20, 00, 000 Shares

0.6 EBIT = 1.2 EBIT – ₹57,60,000

EBIT = ₹96,00,000

(b) Indifference point where EBIT of proposal ‘P’ and proposal ‘R’ is equal:
EBIT 1  0.4  EBIT 1  0.4   48, 00, 000
40, 00, 000 Shares = 20, 00, 000 Shares

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0.6 EBIT 0.6 EBIT  48, 00, 000

40, 00, 000 Shares = 20, 00, 000 Shares

0.30 EBIT = 0.6 EBIT – ₹48,00,000

48, 00, 000

EBIT = 0.30 = 1,60,00,000

(c) Indifference point where EBIT of proposal ‘Q’ and proposal ‘R’ are equal

 EBIT  48, 00, 0001  0.4  EBIT 1  0.4   48, 00, 000
20, 00, 000 Shares = 20, 00, 000 Shares

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

Question 7 (RTP May 19)

Akash Limited provides you the following information:
(₹)
Profit (EBIT ) 2,80,000
Less: Interest on Debenture @ 10% (40,000)
EBT 2,40,000
Less: Income Tax @ 50% (1,20,000)
1,20,000
No. of Equity Shares (₹ 10 each) 30,000
Earnings per share (EPS) 4
Price /EPS (PE) Ratio 10

The company has reserves and surplus of ₹ 7,00,000 and required ₹ 4,00,000

further for modernization. Return on Capital Employed (ROCE) is constant.

Debt (Debt/ Debt + Equity) Ratio higher than 40% will bring the P/E Ratio

down to 8 and increase the interest rate on additional debts to 12%. You

are required to ASCERTAIN the probable price of the share.

 If the additional capital is raised as debt; and

 If the amount is raised by issuing equity shares at ruling market price.

Answer:

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Ascertainment of probable price of shares of Akash Limited

Particulars Plan – I Plan – II

If ₹ 4,00,000 If ₹ 4,00,000 is
is raised as raised by issuing
debt (₹) equity shares (₹)
Earnings Before Interest and Tax (EBIT) 3,60,000 3,60,000
{20% of new capital i.e. 20% of
(₹14,00,000 + ₹4,00,000)} (Refer working
note1)
Less: Interest on old debentures (10% of (40,000) (40,000)
₹4,00,000)
Less: Interest on new debt (12% of (48,000) ---
₹4,00,000)
Earnings Before Tax (EBT) 2,72,000 3,20,000
Less: Tax @ 50% (1,36,000) (1,60,000)
Earnings for equity shareholders (EAT ) 1,36,000 1,60,000
No. of Equity Shares (refer working note 2) 30,000 40,000
Earnings per Share (EPS) 4.53 4.00
Price/ Earnings (P/E) Ratio (refer working ₹8 ₹ 10
note 3)
Probable Price Per Share (PE Ratio × EPS) ₹ 36.24 ₹ 40

Working Notes:
1) Calculation of existing Return of Capital Employed (ROCE):
(₹)
Equity Share capital (30,000 shares × ₹10) 3,00,000
 100  4,00,000
 10, 000  
10% Debentures  10 
Reserves and Surplus 7,00,000
Total Capital Employed 14,00,000
Earnings before interest and tax (EBIT) (given) 2,80,000
2, 80, 000 20%
ROCE = 14, 00, 000 × 100

2) Number of Equity Shares to be issued in Plan-II:

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4, 00, 000
= 40 × 10,000 shares

Thus, after the issue total number of shares = 30,000+ 10,000 = 40,000 shares

3) Debt/Equity Ratio if ₹ 4,00,000 is raised as debt:

8, 00, 000
= 18, 00, 000 × 100 = 44.44%

As the debt equity ratio is more than 40% the P/E ratio will be brought down to

8 in Plan-I

Question 8 (MTP Nov 23)

A Company earns a profit of ₹7,00,000 per annum after meeting its interest

liability of ₹1,00,000 on 10% debentures. The Tax rate is 40%. The number

of Equity Shares of ₹10 each are 1,00,000 and the retained earnings amount

to ₹20,00,000. The company proposes to take up an expansion scheme for

which a sum of ₹10,00,000 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 the rate of 12% or by issuing equity shares at par.

Required:

(i) COMPUTE the Earnings per Share (EPS), if:

 The additional funds were raised as debt

 The additional funds were raised by issue of equity shares.

(ii) ADVISE the company as to which source of finance is preferable.

Answer:

Working Notes:

1) Capital employed before expansion plan: (₹)

Equity shares (₹10 × 1,00,000 shares) 10,00,000

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Debentures {(₹1,00,000/10) x 100} 10,00,000

Retained earnings 20,00,000

Total capital employed 40,00,000

2) Earnings before the payment of interest and tax (EBIT): (₹)

Profit (EBT) 7,00,000

Add: Interest 1,00,000

EBIT 8,00,000

3) Return on Capital Employed (ROCE):

EBIT 8, 00, 000
ROCE = Capital Employed × 100 = 40, 00, 000 × 100 = 20%

4) Earnings before interest and tax (EBIT) after expansion scheme:

After expansion, capital employed = ₹40,00,000 + ₹10,00,000 = ₹ 50,00,000

Desired EBIT = 20% x ₹50,00,000 = ₹10,00,000

Question 9 (MTP Nov 23)

Computation of Earnings Per Share (EPS) under the following options:

Present Expansion Scheme Additional

Situation Funds
Debt Equity
(₹) (₹)
Earnings before 8,00,000 10,00,000 10,00,000
Interest and
Tax (EBIT)
Less: Interest - Old capital 1,00,000 1,00,000 1,00,000

- New capital --- 1,00,000 ---

(10,00,000 × 10%)

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Earnings before Tax (EBT) 7,00,000 8,00,000 9,00,000

Less: Tax (40% of EBT) 2,80,000 3,20,000 3,60,000

PAT 4,20,000 4,80,000 5,40,000
No. of shares outstanding 1,00,000 1,00,000 2,00,000
Earnings per Share (EPS) 4.20 4.80 2.70
 4, 20, 000   4, 80, 000   5, 40, 000 
 1, 00, 000   1, 00, 000   2, 00, 000 
     

1. Advise to the Company: When the expansion scheme is financed by

additional debt, the EPS is higher. Hence, the company should finance the

expansion scheme by raising debt

2. Bhaskar Manufactures Ltd. have Equity Share Capital of ₹ 5,00,000 (face

value ₹100) to meet the expenditure of an expansion programme, the company

wishes to raise ₹ 3,00,000 and is having following four alternative sources

to raise the funds:

Plan A: To have full money from equity shares.

Plan B: To have ₹ 1 lakhs from equity and ₹ 2 lakhs from borrowing from

the financial institution @ 10% p.a.

Plan C: Full money from borrowing @ 10% p.a.

Plan D: ₹1 lakh in equity and ₹ 2 lakhs from preference shares at 8% p.a.

The company is expected to have earnings of ₹ 1,50,000. The corporate tax

is 50%. Suggest a suitable plan of the above four plans to raise the required

funds.

Answer:

Statement showing the EPS under the four plans

Plan A Plan B Plan C Plan D
(₹) (₹) (₹) (₹)
Equity share capital 8,00,000 6,00,000 5,00,000 6,00,000
8% Pref. Share capital --- --- --- 2,00,000
Borrowing @ 10% --- 2,00,000 3,00,000 ---
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8,00,000 8,00,000 8,00,000 8,00,000

E.B.I.T 1,50,000 1,50,000 1,50,000 1,50,000
Less: Interest @ 10% 20,000 30,000
E.B.T 1,50,000 1,30,000 1,20,000 1,50,000
Less: Tax 75,000 65,000 60,000 75,000
Less: Pref Divided 16,000
Earnings available to equity 75,000 65,000 60,000 59,000
shareholders
No. of equity shares (₹100) 8,000 6,000 5,000 6,000
Earnings per share 9.38 10.83 12.00 9.83

Question 10 (MTP1 May 23)

Aeron We Ltd. is considering two alternative financing plans as follows:

Particulars Plan A (₹) Plan B (₹)

Equity shares of ₹ 100 each 90,00,000 90,00,000
Preference Shares of ₹ 100 each --- 20,00,000
9% Debentures 20,00,000 ---
1,10,00,000 1,10,00,000

The indifference point between the plans is ₹7,60,000. Corporate tax rate

is 25%. CALCULATE the rate of dividend on preference shares.

Answer:

Computation of Rate of Preference Dividend

 EBIT – Interest 1  t  EBIT  1  t   Preference Dividend

No. of Equity Shares  N1 No. of Equity Shares  N2
=

7, 60, 000  1, 80, 000  1  0.25 7, 60, 000  1  0.25 Preference Dividend
90, 000 Shares = 90, 000 Shares

4, 35, 000 5, 70, 000  Preference Dividend

90, 000 Shares = 90, 000 Shares

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₹ 4,35,000 = ₹ 5,70,000 – Preference Dividend

Preference Dividend = ₹ 5,70,000 – ₹ 4,35,000 = ₹ 1,35,000

Preference Dividend
Rate of Dividend = Preference Share Capital × 100

1, 35, 000
= 20, 00, 000 × 100 = 6.75%

Question 11 (MTP1 May 23)

RML Limited needs ₹6,50,00,000 for the Expansion purposes. The following

three plans are feasible:

(I) The Company may issue 6,50,000 equity shares at ₹100 per share.

(II) The Company may issue 4,00,000 equity shares at ₹100 per share and

2,50,000 debentures of ₹100 denomination bearing a 9% rate of

interest.

(III) The Company may issue 4,00,000 equity shares at ₹100 per share and

2,50,000 cumulative preference shares at ₹100 per share bearing a

9% rate of dividend.

(i) If the Company's earnings before interest and taxes are ₹15,62,500,

₹22,50,000, ₹62,50,000, ₹93,75,000 and ₹1,56,25,000, CALCULATE

the earnings per share under each of three financial plans? Assume a

Corporate Income tax rate of 25%.

(ii) WHICH alternative would you recommend and why?

Answer:

Computation of EPS under three-financial plans.

Plan I: Equity Financing

(₹) (₹) (₹) (₹) (₹)
EBIT 15,62,500 22,50,000 62,50,000 93,76,000 1,56,25,000
Interest 0 0 0 0 0
EBT 15,62,500 22,50,000 62,50,000 93,76,000 1,56,25,000

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Less Tax @ 3,90,625 5,62,500 15,62,500 23,43,750 39,06,250

25%
PAT 11,71,875 16,87,500 46,87,500 70,31,250 1,17,18,750
No. of equity 6,50,000 6,50,000 6,50,000 6,50,000 6,50,000

shares

EPS 1.80 2.60 7.21 10.82 18.03

Plan II: Debt – Equity Mix

(₹) (₹) (₹) (₹) (₹)

EBIT 15,62,500 22,50,000 62,50,000 93,76,000 1,56,25,000
Less: 22,50,000 22,50,000 22,50,000 22,50,000 22,50,000
Interest
EBT (6,87,500) 0 40,00,000 71,25,000 1,33,75,000
Less Tax @ 1,71,875* 0 10,00,000 17,81,250 33,43,750
25%
PAT (5,15,625) 0 30,00,000 53,43,750 1,00,31,250
No. of equity 4,00,000 4,00,000 4,00,000 4,00,000 4,00,000
shares
EPS (₹) (1.29) 0 7.50 13.36 25.08
* The Company can set off losses against the overall business profit or may carry

forward it to next financial years.

Plan III: Preference Shares – Equity Mix

(₹) (₹) (₹) (₹) (₹)
EBIT 15,62,500 22,50,000 62,50,000 93,75,000 1,56,25,000
Less: Interest 0 0 0 0 0
EBT 15,62,500 22,50,000 62,50,000 93,75,000 1,56,25,000
Less Tax @ 25% 3,90,625 5,62,500 15,62,500 23,43,750 39,06,250

PAT 11,71,875 16,87,500 46,87,500 70,31,250 1,17,18,750

Less: Pref. 22,50,000 22,50,000 22,50,000 22,50,000 22,50,000
Dividend*
PAT after €pref. (10,78,125) (5,62,500) 24,37,500 47,81,250 94,68,750
dividend

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No. of equity 4,00,000 4,00,000 4,00,000 4,00,000 4,00,000

shares
EPS (₹) (2.70) (1.41) 6.09 11.95 23.67

* In case of cumulative preference shares, the company has to pay cumulative

dividend to preference shareholders.

(ii) In case of lower EBIT Plan I i.e Equity Financing is better however in case of

higher EBIT Plan II i.e Debt=Equity Mix is best.

Question 12 (MTP2 Nov 22)

Axar Ltd. has a Sales of ₹ 68,00,000 with a Variable cost Ratio of 60%.

The company has fixed cost of ₹16,32,000. The capital of the company

comprises of 12% long term debt,

₹1,00,000 Preference Shares of ₹ 10 each carrying dividend rate of 10%

and 1,50,000 equity shares.

The tax rate applicable for the company is 30%.

At current sales level, DETERMINE the Interest, EPS and amount of debt

for the firm if a 25% decline in Sales will wipe out all the EPS.

Answer:

Break Even Sales = ₹ 6800000×0.75 = ₹ 51,00,000

Income Statement

Original Calculation of Now at

(₹) Interest at BEP Present
(backward Level (₹)
calculation) (₹)
Sales 68,00,000 51,00,000 68,00,000
Less: Variable Cost 40,80,000 30,60,000 40,80,000
Contribution 27,20,000 20,40,000 27,20,000
Less: Fixed Cost 16,32,000 16,32,000 16,32,000
EBIT 10,88,000 4,08,000 10,88,000
Less: Interest (EBIT-PBT) ? 3,93,714 3,93,714

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PBT ? 14.286(10,000/70%) 6,94,286

Less: Tax @ 30%(or PBT-PAT) ? 4.286 2,08,286
PAT ? 10,000(Nil + 10,000) 4,86,000
Less: Preference Dividend 10,000 10,000 10,000
Earnings for Equity share ? Nil (at BEP) 4,76,000
holders
Number of Equity Shares 1,50,000 1,50,000 1,50,000
EPS ? --- 3.1733

So, Interest=₹3,93,714, EPS=₹3.1733,

Amount of debt=3,93,714/12%=₹ 32,80,950

Question 13 (MTP2 May 22)

Following data is available in respect of two companies having same business
risk: Capital employed = ₹ 4,00,000, EBIT = ₹ 60,000 and Ke = 12.5%
Sources Levered Company (₹) Unlevered Company (₹)
Debt (@ 10%) 2,00,000 Nil
Equity 2,00,000 4,00,000

An investor is holding 15% shares in levered company. CALCULATE the

increase in annual earnings of investor if he switches his holding from Levered

to Unlevered company.

Answer:

Valuation of firms
Particulars Levered Unlevered Firm
Firm (₹) (₹)
EBIT 60,000 60,000
Less: Interest on debt (10% × ₹ 2,00,000) (20,000) Nil
Earnings available to Equity shareholders 40,000 60,000
Ke 12.5% 12.5%
Value of Equity (S) 3,20,000 4,80,000
(Earnings available to Equity
shareholders/Ke)
Debt (D) 2,00,000 Nil
Value of Firm (V) = S + D 5,20,000 4,80,000

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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.

Investment & Borrowings (₹)

Sell shares in Levered company (₹ 3,20,000 x 15%) 48,000

Borrow money (₹ 2,00,000 x 15%) 30,000

Buy shares in Unlevered company 78,000

Change in Return (₹)

Income from shares in Unlevered company 9,750

(₹ 78,000 x 12.5%)

Less: Interest on loan (₹ 30,000 x 10%) 3,000

Net Income from unlevered firm 6,750

Less: Income from Levered firm (₹ 48,000 x 12.5%) 6,000

Incremental Income due to arbitrage 750

Question 14 (MTP2 May 22)

a. 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 maximising earnings per share. It has three alternatives

to finance the project- 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

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₹ 2,50,000 and up to ₹ 10,00,000 and at 20% over ₹ 10,00,000. The

tax rate applicable to the company is 50%. ANALYSE, which form of

financing should the company choose?

b. “Operating risk is associated with cost structure, whereas financial risk is

associated with capital structure of a business concern.” Critically

EXAMINE this statement.

Answer:

a) Calculation of Earnings per share for three alternatives to finance the

project
Particulars Alternatives
I II III
To raise debt of To raise debt To raise debt of ₹
₹2,50,000 and of ₹ 15,00,000 and equity
equity of 10,00,000 and of ₹ 10,00,000 (₹)
₹22,50,000 (₹) equity of ₹
15,00,000 (₹)
Earnings before interest 5,00,000 5,00,000 5,00,000
and tax
Less: Interest on debt at 25,000 1,37,500 2,37,500
the rate of (10% on ₹2,50,000) (10% on ₹ (10% on ₹2,50,000)
2,50,000) (15% on ₹7,50,000)
(15% on ₹ (20% on ₹5,00,000)
7,50,000)
Earnings before tax 4,75,000 3,62,500 2,62,500
Less: Tax (@ 50%) 2,37,500 1,81,250 1,31,250
Earnings after tax: (A) 2,37,500 1,81,250 1,31,250
Number of shares :(B) 15,000 10,000 8,000
(Refer to working note)
Earnings per share: 15,833 18,125 16,406
(A)/(B)
So, the earning per share (EPS) is higher in alternative II i.e. if the company

finance the project by raising debt of ₹ 10,00,000 and issue equity shares of ₹

15,00,000. Therefore, the company should choose this alternative to finance the

project.

Working Note:
Alternatives

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I II III
Equity financing : (A) ₹ 22,50,000 ₹ 15,00,000 ₹ 10,00,000
Market price per share : (B) ₹ 150 ₹ 150 ₹ 125
Number of equity share : (A)/(B) 15,000 10,000 8,000

b) “Operating risk is associated with cost structure whereas financial risk is

associated with capital structure of a business concern”.

Operating risk refers to the risk associated with the firm’s operations. It is

represented by the variability of earnings before interest and tax (EBIT). The

variability in turn is influenced by revenues and expenses, which are affected by

demand of firm’s products, variations in prices and proportion of fixed cost in

total cost. If there is no fixed cost, there would be no operating risk. Whereas

financial risk refers to the additional risk placed on firm’s shareholders as a

result of debt and preference shares used in the capital structure of the

concern. Companies that issue more debt instruments would have higher financial

risk than companies financed mostly by equity.

Question 15 (MTP2 Dec 21)

ABC Limited is setting up a project with a capital outlay of ₹ 90,00,000. It

has two alternatives in financing the project cost.

Alternative-I: 100% equity finance by issuing equity shares of ₹ 10 each

Alternative-II: Debt-equity ratio 2:1 (issuing equity shares of ₹ 10 each)

The rate of interest payable on the debts is 18% p.a. The corporate tax

rate is 30%. CALCULATE the indifference point between the two alternative

methods of financing.

Answer:

Calculation of Indifference point between the two alternatives of financing.

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Alternative-I By issue of 9,00,000 equity shares of ₹10 each amounting to ₹ 90

lakhs. No financial charges are involved.

Alternative-II By raising the funds in the following way: Debt = ₹ 60 lakhs

Equity = ₹ 30 lakhs (3,00,000 equity shares of ₹ 10 each)

18
Interest payable on debt = 60,00,000 × 100 = ₹ 10,80,000

The difference point between the two alternatives is calculated by:

 EBIT  I11  t   EBIT  I21  t 

E1 = E2

 EBIT  01  0.30  EBIT  10, 80, 0001  0.70

9, 00, 000 = 3, 00, 000

EBIT 0.70 0.70  EBIT  10, 80, 000

3 = 1

EBIT = 3EBIT−32,40,000

−2 EBIT = −32,40,000
32, 40, 000
EBIT = 2 EBIT = ₹ 16,20,000

Therefore, at EBIT of ₹ 16,20,000, earnings per share for the two alternatives

is equal.

Question 16 (MTP2 Dec 21)

Sophisticated Limited is considering three financing plans. The key

information is as follows:

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

(b) Plans of Financing Proportion:

Plans Equity Debt Preference Shares
A 100% --- ---
B 50% 50% ---

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C 50% --- 50%

(c) Cost of debt 10%

Cost of preference shares 10%

(d) Tax rate 30%

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

of ₹ 10 per share.

(f) Expected EBIT is ₹ 10,00,000.

You are required to DETERMINE for each plan: -

1. Earnings per share (EPS)

2. The financial break-even point.

3. Indicate if any of the plans dominate and compute the EBIT range among

the plans for indifference.

Answer:

(i) Computation of Earnings per share (EPS)

Plant A B C
Earnings before 10,00,000 10,00,000 10,00,000
interest and tax
(EBIT)
Less: Interest --- (20,000) ---
charges (10% × ₹ 2 Lakhs)
Earnings before 10,00,000 9,80,000 10,00,000
tax (EBT)
Less: Tax (@ 30%) (3,00,000) (2,94,000) (3,00,000)

Earnings after tax 7,00,000 6,86,000 7,00,000

(EAT)
Less: Preference --- --- (20,000
Dividend (10% × ₹ 2 Lakhs)
Earnings available 7,00,000 6,86,000 6,80,000
for Equity
shareholders (A)
No. of Equity 20,000 10,000 10,000
shares (B) (₹ 4 Lakhs + ₹ 20) (₹ 2 Lakhs + ₹ 20) (₹ 2 Lakhs + ₹ 20)

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EPS ₹ [(A) ÷ (B)] 35 68.6 68

(ii) Calculation of Financial Break-even point

Financial break-even point is the earnings which are equal to the fixed finance

charges and preference dividend.

Plan A: Under this, plan there is no interest or preference dividend payment.

Hence, the Financial Break- even point will be zero.

Plan B: Under this plan, there is an interest payment of ₹ 20,000 and no

preference dividend. Hence, the Financial Break-even point will be ₹ 20,000

(Interest charges).

Plan C: Under this plan, there is no interest payment but an after tax preference

dividend of ₹ 20,000 is paid. Hence, the Financial Break- even point will be before

tax earnings of ₹ 28,571 (i.e. ₹ 20,000 ÷ 0.7)

(iii) Computation of indifference point between the plans.

The indifference between two alternative methods of financing is calculated by

applying the following formula.

 EBIT  I11  t   EBIT  I21  t 

E1 = E2

Where,

EBIT = Earnings before interest and tax.

l1 = Fixed charges (interest or pref. dividend) under Alternative 1

l2 = Fixed charges (interest or pref. dividend) under Alternative 2

T = Tax rate

E1 = No. of equity shares in Alternative 1

E2 = No. of equity shares in Alternative 2

Now, we can calculate indifference point between different plans of financing.

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a) Indifference point where EBIT of Plan A and Plan B is equal

 EBIT  01  0.3  EBIT  20, 0001  0.3

20, 000 = 10, 000

0.7 EBIT (10,000) = (0.7 EBIT – 14,000) (20,000)

7,000 EBIT = 14,000 EBIT – 28 crores

EBIT = 40,000

b) Indifference point where EBIT of Plan A and Plan C is equal

 EBIT  01  0.3  EBIT  01  0.3  20, 000

20, 000 = 10, 000

0.7 EBIT (10,000) = (0.7 EBIT – 20,000) (20,000)

7,000 EBIT = 14,000 EBIT – 40 crores

EBIT = 57,142.86

c) Indifference point where EBIT of Plan B and Plan C are equal

 EBIT  20, 0001  0.3  EBIT  01  0.3  20, 000

10, 000 = 10, 000

(0.7 EBIT – 14,000) (10,000) = (0.7 EBIT – 20,000) (10,000)

7,000 EBIT – 14 crore = 7,000 EBIT - 20 crore

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

Question 17 (MTP1 May 21)

HN Limited is considering total investment of ₹ 20 lakhs. You are required

to CALCULATE the level of earnings before interest and tax (EBIT) at which

the EPS indifference point between the following financing alternatives will

occur:

(i) Equity share capital of ₹ 12,00,000 and 14% debentures of ₹

8,00,000.

(Or)
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(ii) Equity share capital of ₹ 8,00,000, 16% preference share capital of

₹ 4,00,000 and 14% debentures of ₹ 8,00,000.

Assume the corporate tax rate is 30% and par value of equity share is ₹10

in each case.

Answer:

Computation of level of earnings before interest and tax (EBIT)

In case alternative (i) is accepted, then the EPS of the firm would be:

EBIT – Interest 1  Tax Rate 

EPS Alternative (i) = No. of Equity Shares

 EBIT  0.14  8, 00, 0001  03

= 1, 20, 000 Shares

In case the alternative (ii) is accepted, then the EPS of the firm would be

 EBIT  Interest 1  Tax Rate   PD

EPS Alternative (ii) = No. of Equity Shares

 EBIT  0.14  8, 00, 0001  03  0.16  4, 00, 000

= 80, 000 Shares

In order to determine the indifference level of EBIT, the EPS under the two

alternative plans should be equated as follows:

 EBIT  0.14  8, 00, 0001  03  EBIT  0.14  8, 00, 0001  03  0.16  4, 00, 000
= 1, 20, 000 Shares = 80, 000 Shares

=
0.7 EBIT 78, 400 0.7 EBIT 1, 42, 400
Or, 1, 20, 000 = 80, 000

Or 1.40 EBIT − ₹ 1,56,800 = 2.10 EBIT − ₹ 4,27,200

Or 0.70 EBIT = ₹ 2,70,400

2, 70, 400
Or EBIT = 0. 7

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Or EBIT = ₹ 3,86,285.71 (approx.)

Question 18 (MTP Nov 19)

RPS Company presently has ₹ 36,00,000 in debt outstanding bearing an

interest rate of 10 percent. It wishes to finance a ₹ 40,00,000 expansion

programme and is considering three alternatives: additional debt at 12 per

cent interest, preferred stock with an 11 per cent dividend, and the sale of

common stock at ₹ 16 per share. The company presently has 8,00,000 shares

of common stock outstanding and is in a 40 per cent tax bracket.

1. If earnings before interest and taxes are presently ₹ 15,00,000,

CALCULATE earnings per share for the three alternatives, assuming no

immediate increase in profitability?

2. CALCULATE indifference point between debt and common stock.

Answer:

1.
(₹ in Thousands)
Debt Preferred Common
Stock Stock
EBIT 1,500 1,500 1,500
Interest on existing debt 360 360 360
Interest on new debt 480
Profit before taxes 660 1,140 1,140
Taxes 264 456 456
Profit after taxes 396 684 684
Preferred stock dividend 440
Earnings available to common 395 244 684
shareholders
Number of shares 800 800 1,050
Earnings per share .495 .305 .651

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(ii) Mathematically, the indifference point between debt and common stock is (Rs

in thousands):

EBIT * 840 EBIT * 360

800 = 1, 050

EBIT* (1,050) – ₹ 840(1,050) = EBIT* (800) – ₹ 360 (800)

250 EBIT* = ₹ 5,94,000 EBIT* = ₹ 2,376

Question 19 (MTP1 Nov 18)

Cost of debt and preference shares is 10% each.

Tax rate – 50%

Equity shares of the face value of ₹ 10 each will be issued at a premium of

₹ 10 per share.

Total investment to be raised ₹ 40,00,000.

Expected earnings before interest and tax ₹ 18,00,000.

Proposed Equity shares (%) Debts (%) Preference Shares (%)

P 100 --- ---

Q 50 50 ---

R 50 --- 50

From the above proposals the management wants to take advice from you for

appropriate plan after computing the following:

•Earnings per share

•Financial break-even-point

COMPUTE the EBIT range among the plans for indifference. Also indicate if
any of the plans dominate.
Answer:

Computation of Earnings per Share (EPS)

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Plans P (₹) Q (₹) R (₹)

Earnings before interest & tax 18,00,000 18,00,000 18,00,000
(EBIT)
Less: Interest charges --- (2,00,000) ---
Earnings before tax (EBT) 18,00,000 16,00,000 18,00,000
Less: Tax @ 50% (9,00,000) (8,00,000) (9,00,000)
Earnings after tax (EAT) 9,00,000 8,00,000 9,00,000
Less: Preference share dividend --- --- (2,00,000)

Earnings available for equity 9,00,000 8,00,000 7,00,000

shareholders
No. of equity shares 2,00,000 1,00,000 1,00,000
E.P.S 4.5 8 7

(ii) Computation of Financial Break-even Points

Proposal ‘P’ = 0

Proposal ‘Q’ = ₹ 2,00,000 (Interest charges)

Proposal ‘R’ = Earnings required for payment of preference share dividend i.e.

₹ 2,00,000 x 0.5 (Tax Rate) = ₹ 4,00,000

(iii) Computation of Earnings per Share (EPS)

Combination of Proposals

a) Indifference points where EBIT of proposal “P” and proposal ‘Q’ is equal:

EBIT  1  0.5  EBIT  2, 00, 0001  0.5

2, 00, 000 Shares = 1, 00, 000 Shares

0.5 EBIT = EBIT – ₹ 2,00,000

EBIT = ₹ 4,00,000

b) Indifference points where EBIT of proposal ‘P’ and proposal ‘R’ is equal:

EBIT  1  0.5 EBIT 1  0.5  2, 00, 000

2, 00, 000 Shares = 1, 00, 000 Shares
0.5 EBIT 0.5 EBIT  2, 00, 000
2, 00, 000 Shares = 1, 00, 000 Shares

0.25 EBIT = 0.5 EBIT – ₹ 2,00,000

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2, 00, 000
EBIT = 0.25 = ₹ 8,00,000

c) Indifference points where EBIT of proposal ‘Q’ and proposal ‘R’ are equal

 EBIT  2, 00, 0001  0.5 EBIT 1  0.5  2, 00, 000

1, 00, 000 Shares = 1, 00, 000 Shares

0.5 EBIT – ₹1,00,000 = 0.5 EBIT – ₹2,00,000

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-

Question 20 (MTP May 18)

Sundaram Ltd. discounts its cash flows at 16% and is in the tax bracket of

35%. For the acquisition of a machinery worth ₹10,00,000, it has two options

– either to acquire the asset by taking a bank loan @ 15% p.a. repayable in

5 yearly instalments of ₹ 2,00,000 each plus interest or to lease the asset

at yearly rentals of ₹ 3,34,000 for five (5) years. In both the cases, the

instalment is payable at the end of the year. Depreciation is to be applied

at the rate of 15% using ‘written down value’ (WDV) method. You are required

to STATE with reason which of the financing options is to be exercised.

Year 1 2 3 4 5
P. V. Factor @ 16% 0.862 0.743 0.641 0.552 0.476

Answer:

Alternative I: Acquiring the asset by taking bank loan:

Year 1 2 3 4 5
a) Interest 1,50,000 1,20,000 90,000 60,000 30,000
(@15% p.a. on
opening balance)
Depreciation 1,50,000 1,27,500 1,08,375 92,119 78,301
(@15%WDV)
3,00,000 2,47,500 1,98,375 1,52,119 1,08,301
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b) Tax shield (@35%) 1,05,000 86,625 69,431 53,242 37,905

Interest less Tax 45,000 33,375 20,569 6,758 (7,905)
shield (a)-(b)
Principal Repayment 2,00,000 2,00,000 2,00,000 2,00,000 2,00,000

Total cash outflow 2,45,000 2,33,375 2,20,569 2,06,758 1,92,095

Discounting Factor 0.862 0.743 0.641 0.552 0.476
@ 16%
Present Value 2,11,190 1,73,398 1,41,385 1,14,130 91,437

Total P.V of cash outflow = ₹7,31,540

Alternative II: Acquire the asset on lease basis

Year Lease Tax Shield Net Cash Discount Present

Rentals (₹) @ 35% Outflow Factor Value
1 3,34,000 1,16,900 2,17,100 0.862 1,87,140
2 3,34,000 1,16,900 2,17,100 0.743 1,61,305
3 3,34,000 1,16,900 2,17,100 0.641 1,39,161
4 3,34,000 1,16,900 2,17,100 0.552 1,19,839
5 3,34,000 1,16,900 2,17,100 0.476 1,03,340
Present value of Total Cash out flow 7,10,785
By making analysis of both the alternatives, it is observed that the present value

of the cash outflow is lower in alternative II by ₹ 20,755 (i.e. ₹ 731,540 – ₹

7,10,785) Hence, it is suggested to acquire the asset on lease basis.

Question 21 (MTP May 18)

XYZ Ltd. is considering three financial plans for which the key information

is as below:

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

(ii) Plans of Financing Proportion

Plans Equity Debt Preference Shares
A 100% --- ---
B 50% 50% ---

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C 50% --- 50%

(iii) Cost of debt 8%

Cost of preference shares 8%

(iv) Tax Rate is 50%

(v) Equity shares of the face value of ₹10 each will be issued at a premium

of ₹10 per share.

(vi) Expected EBIT is ₹1,60,000

DETERMINE for each plan:

(i) Earnings per share (EPS)

(ii) Financial break-even point.

(iii) COMPUTE the EBIT range among the plans A and C for point of

indifference.

Answer:

(i) Computation of Earnings per Share (EPS) for each Plan

Particulars Plan A (₹) Plan B (₹) Plan C (₹)
Earnings Before Interest Tax (EBIT) 1,60,000 1,60,000 1,60,000
Less: Interest on debt at 8% --- (16,000) ---
Earnings Before Tax 1,60,000 1,44,000 1,60,000
Less: Tax at 50% 80,000 72,000 80,000
Earnings After Tax 80,000 72,000 80,000
Less: Preference Dividend at 8% --- --- 16,000
Earnings available for equity 80,000 72,000 64,000
shareholders
Number of Equity Shares 20,000 10,000 10,000
Earnings per share (EPs) 4.00 7.20 6.40

(ii) Financial Break-even Point for Each Plan

Plan A: There is no fixed financial charges, hence the financial break -even point
for Plan A is zero.

Plan B: Fixed interest charges is ₹16,000, hence the financial break-even point

for Plan B is ₹16,000

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Plan C: Fixed charge for preference dividend is ₹16,000, hence, the financial

break-even point for Plan C is ₹16,000

(iii) Indifference point between Plan A and C

 X  01  0.5  0  X  01  0.5  16, 000

20, 000 = 10, 000 Shares

0.5X 0.5X  16, 000

o.5 X or 20, 000 = 10, 000 or, 0.5X – X = -32,000 or, 0.5X = 32,000

or, X = ₹ 64,000

Thus point of indifference between plan A and C is ₹64,000.

Question 22 (RTP May 22)

The following data relates to two companies belonging to the same risk class:
Particulars Bee Limited Cee Limited
12% Debt ₹ 27,00,000 ---
Equity Capitalization Rate --- 18
Expected Net Operating Income ₹ 9,00,000 ₹ 9,00,000

You are required to:

(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.

Answer:

a) Assuming no tax as per MM Approach.

Calculation of Value of Firms ‘Bee Ltd.’ and ‘Cee Ltd’ according to MM

Hypothesis Market Value of ‘Cee Ltd’ [Unlevered(u)]

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Total Value of Unlevered Firm (Vu) = [NOI/Ke] = 9,00,000/0.18 = ₹ 50,00,000 Ke

of Unlevered Firm (given) = 0.18

Ko of Unlevered Firm (Same as above = Ke as there is no debt) = 0.18

Market Value of ‘Bee Ltd’ [Levered Firm (I)]

Total Value of Levered Firm (VL) = Vu + (Debt× Nil)

= ₹ 50,00,000 + (27,00,000 × nil) = ₹ 50,00,000

Computation of Equity Capitalization Rate and Weighted Average Cost of

Capital (WACC)
Particulars Bee Limited
Net Operating Income (NOI) 9,00,000
Less: Interest on Debt (I) 3,24,000
Earnings of Equity Shareholders (NI) 5,76,000
Overall Capitalization Rate (Ko) 0.18
Total Value of Firm (V = NOI/Ko) 50,00,000
Less: Market Value of Debt 27,00,000
Market Value of Equity (S) 23,00,000
Equity Capitalization Rate [Ke = NI /S] 0.2504
Weighted Average Cost of Capital (Ko)* 0.18
Ko = (Ke × S/V) + (Kd × D/V)

*Computation of WACC Bee Limited

Component of Capital Amount Weight Cost of Capital WACC

Equity 23,00,000 0.46 0.2504 0.1152
Debt 27,00,000 0.54 0.12* 0.0648
Total 50,00,000 0.18

*Kd = 12% (since there is no tax) WACC = 18%

b) Assuming 40% taxes as per MM Approach

Calculation of Value of Firms ‘Bee Ltd.’ and ‘Cee Ltd’ according to MM

Hypothesis Market Value of ‘Cee Ltd’ [Unlevered(u)]

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Total Value of unlevered Firm (Vu) = [NOI (1 - t)/Ke] = 9,00,000 (1 – 0.40)] / 0.18

= ₹ 30,00,000

Ke of unlevered Firm (given) = 0.18

Ko of unlevered Firm (Same as above = Ke as there is no debt) = 0.18

Market Value of ‘Bee Ltd’ [Levered Firm (I)]

Total Value of Levered Firm (VL) = Vu + (Debt× Tax)

= ₹ 30,00,000 + (27,00,000 × 0.4) = ₹ 40,80,000

Computation of Weighted Average Cost of Capital (WACC) of ‘Cee Ltd.’

= 18% (i.e. Ke = Ko)

Computation of Equity Capitalization Rate and Weighted Average Cost of

Capital (WACC) of Bee Ltd
Particulars Bee Limited
Net Operating Income (NOI) 9,00,000
Less: Interest on Debt (I) 3,24,000
Earnings Before Tax (EBT) 5,76,000
Less: Tax @ 40% 2,30,400
Earnings of Equity Shareholders (NI) 3,45,600
Total Value of Firm (V) as calculated above 40,80,000
Less: Market Value of Debt 27,00,000
Market Value of Equity (S) 13,80,000
Equity Capitalization Rate [Ke = NI /S] 0.2504
Weighted Average Cost of Capital (Ko)* 13.23
Ko = (Ke × S/V) + (Kd × D/V)

Computation of WACC Bee Ltd.

Component of Capital Amount Weight Cost of Capital WACC

Equity 13,80,000 0.338 0.2504 0.0846
Debt 27,00,000 0.662 0.072* 0.0477
Total 40,80,000 0.1323
*Kd= 12% (1- 0.4) = 12% × 0.6 = 7.2% WACC = 13.23%

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Question 23 (RTP Dec 21)

Blue Ltd., an all equity financed company is considering the repurchase of ₹

275 lakhs equity shares and to replace it with 15% debentures of the same

amount. Current market value of the company is ₹ 1,750 lakhs with its cost

of capital of 20%. The company's Earnings before Interest and Taxes (EBIT)

Assuming the corporate tax rate as 30%, you are required to CALCULATE

the impact on the following on account of the change in the capital structure

as per Modigliani and Miller (MM) Approach:

(i) Market value of the company

(ii) Overall Cost of capital

(iii) Cost of equity

Answer:

Workings:
Net Income  NI  for Equityholders
Market Value of Equity = Ke

Net Income  NI  for Equityholders

₹ 1,750 Lakhs = 0.20

Net Income to equity holders/EAT = ₹ 350 lakhs

EAT 350 Lakhs
Therefore, EBIT 1  t  = 1  0.3 = ₹ 500 Lakhs

Income Statement
All Equity Equity & Debt
(₹ in Lakhs) (₹ in Lakhs)
EBIT (as calculated above) 500 500
Interest on ₹ 275 lakhs @ 15% --- 41.25
EBT --- 458.75
Tax @ 30% 500 137.63
Income available to equity holders 150 321.12

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350

(i) Market value of the company

Market value of levered firm = Value of unlevered firm + Tax Advantage

= ₹ 1,750 lakhs + (₹ 275 lakhs x 0.3) = ₹ 1,832.5 lakhs

Change in market value of the company = ₹ 1,832.5 lakhs – ₹ 1,750 lakhs

= ₹ 82.50 lakhs

The impact is that the market value of the company has increased by ₹ 82.50
lakhs due to replacement of equity with debt

(ii) Overall Cost of Capital

Market Value of Equity = Market value of levered firm - Equity repurchased

= ₹ 1,832.50 lakhs – ₹ 275 lakhs = ₹ 1,557.50 lakhs
Cost of Equity (Ke) = (Net Income to equity holders/Market value of

equity) × 100

= (₹ 321.12 lakhs / ₹ 1,557.50 lakhs ) x 100 = 20.62%

Cost of debt (Kd) = I (1 - t) = 15 (1 - 0.3) = 10.50%

Component of Capital Amount Cost of Capital Weight WACC (Ko)
(₹ in Lakhs)
Equity 1,557.50 20.62 0.85 17.53
Debt 275.00 10.50 0.15 1.58
Total 1,832.50 1 19.11

The impact is that the Overall Cost of Capital or Ko has fallen by 0.89% (20% -

19.11%) due to the benefit of tax relief on debt interest payment.

(iii) Cost of Equity

The impact is that cost of equity has risen by 0.62% (20.62% - 20%) due to the

presence of financial risk i.e. introduction of debt in capital structure.

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Note: Cost of Capital and Cost of equity can also be calculated with the help of

following formulas, though there will be no change in the final answers.

Cost of Capital (Ko) = Keu [1 – (t x L)] Where,

Keu = Cost of equity in an unlevered company

t = Tax Rate

Debt
L = 0.2 Debt  Equity 0

  275 Lakhs  
1   0.30  
1, 832.5 Lakhs  
So, Ko = 0.20 +  

= 0.191 or 19.10% (approx.)

Debt 1  t 
Cost of Equity (Ke) = Keu + (Keu – Kd) Equity

Where,

Keu = Cost of equity in an unlevered company

Kd = Cost of Debt

t = Tax Rate

275 lakhs 1 - 0.3

So, Ke = 0.20 + (0.20 + 0.15) 1, 557.5 lakhs = 0.2062 or 20.62%

Question 24 (RTP July 21)

Zordon Ltd. has net operating income of ₹5,00,000 and total capitalization

of ₹ 50,00,000 during the current year. The company is contemplating to

introduce debt financing in capital structure and has various options for the

same. The following information is available at different levels of debt value:

Debt Value (₹) Interest Rate (%) Equity Capitalisation Rate (%)
0 --- 10.00
5,00,000 6.0 10.50
10,00,000 6.0 11.00

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15,00,000 6.2 11.30

20,00,000 7.0 12.40
25,00,000 7.5 13.50
30,00,000 8.0 16.00
Assuming no tax and that the firm always maintains books at book values,

you are REQUIRED to calculate:

(i) Amount of debt to be employed by firm as per traditional approach.

(ii) Equity capitalization rate, if MM approach is followed.

Answer:

a) Amount of debt to be employed by firm as per traditional approach

Calculation of Equity, Wd and We

Total Capital Debt Wd Equity value Wd
(₹) (₹) (₹)
(a) (b) (a)/(b) (c) = (a) ⎼ (b) (c)/(a)
50,00,000 0 --- 50,00,000 1.0
50,00,000 5,00,000 0.1 45,00,000 0.9
50,00,000 10,00,000 0.2 40,00,000 0.8
50,00,000 15,00,000 0.3 35,00,000 0.7
50,00,000 20,00,000 0.4 30,00,000 0.6
50,00,000 25,00,000 0.5 25,00,000 0.5
50,00,000 30,00,000 0.6 20,00,000 0.4

Statement of Weighted Average Cost of Capital (WACC)

Ke We Kd Wd Ke We Kd Wd Ke
(1) (2) (3) (4) (5) = (1) × (2) (6) = (3) × (4) (7) = (5) + (6)
0.100 1.0 --- --- 0.100 --- 0.100
0.105 0.9 0.060 0.1 0.095 0.006 0.101
0.110 0.8 0.060 0.2 0.088 0.012 0.100
0.113 0.7 0.062 0.3 0.079 0.019 0.098
0.124 0.6 0.070 0.4 0.074 0.028 0.102
0.135 0.5 0.075 0.5 0.068 0.038 0.106
0.160 0.4 0.080 0.6 0.064 0.048 0.112

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So, amount of Debt to be employed = ₹ 15,00,000 as WACC is minimum at this

level of debt i.e. 9.8%.

b) As per MM approach, cost of the capital (Ko) remains constant and cost of

equity increases linearly with debt.

Net Operation Income  NOI 

Value of a firm = Ko

5, 00, 000
5,00,000 = Ko

5, 00, 000
Ko = 50, 00, 000 = 10%

Statement of Equity Capitalization rate (ke) under MM approach

Ke = Ko +
Debt Equity
Debt/Equity Ke Kd Ke – Kd (Ke – Kd)
(₹) (₹)
Debt Equity
(1) (2) (3)= (1)/(2) (4) (5) (6) = (4) (7) = (4) +
– (5) (6) × (3)
0 50,00,000 0 0.10 --- 0.100 0.100
5,00,000 45,00,000 0.11 0.10 0.060 0.040 0.104
10,00,000 40,00,000 0.25 0.10 0.060 0.040 0.110
15,00,000 35,00,000 0.43 0.10 0.062 0.038 0.116
20,00,000 30,00,000 0.67 0.10 0.070 0.038 0.120
25,00,000 25,00,000 1.00 0.10 0.075 0.025 0.125
30,00,000 20,00,000 1.50 0.10 0.080 0.020 0.130

Question 25 (RTP Nov 18)

Rounak Ltd. is an all equity financed company with a market value of ₹

25,00,000 and cost of equity (Ke) 21%. The company wants to buyback equity

shares worth ₹ 5,00,000 by issuing and raising 15% perpetual debt of the

same amount. Rate of tax may be taken as 30%. After the capital

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restructuring and applying MM Model (with taxes), you are required to

COMPUTE:

1.Market value of J Ltd.

2.Cost of Equity (Ke)

3. Weighted average cost of capital (using market weights) and comment on

it.

Answer:

Value of a company (V) = Value of equity (S) + Value of debt (D)

Net Income  NI 
₹ 25,00,000 = Ke + 5,00,000

Or, Net Income (NI) = 0.21 (₹ 25,00,000 – ₹ 5,00,000)

Market Value of Equity = ₹ 25,00,000

Ke =21%

Net Income  NI  for Equityholders

Ke = Market Value of Equity

Net Income  NI  for Equityholders

0.21 = ₹ 25,00,000

Net income for equity holders = ₹ 5,25,000

EBIT = 5,25,000/0.7 = ₹ 7,50,000

All Equity Debt & Equity

(₹) (₹)
EBIT 7,50,000 7,50,000
Interest to debt-holders --- (75,000)
EBT 7,50,000 6,75,000
Taxes (30%) (2,25,000) (2,02,500)
Income available to equity shareholders 5,25,000 4,72,500
Income to debt holders plus income available to 5,25,000 5,47,500
shareholders

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Present value of tax-shield benefits = ₹ 5,00,000 × 0.30 = ₹ 1,50,000

(i) Value of Restructured firm

= ₹ 25,00,000 + ₹ 1,50,000 = ₹ 26,50,000

(ii) Cost of Equity (Ke)

Total Value = ₹26,50,000

Less: Value of Debt = ₹5,00,000

Value of Equity = ₹21,50,000

4, 72, 500
Ke = 21, 50, 000 = 0.219 = 21.98%

(iii) WACC (on market value weight)

Cost of Debt (after tax) = 15% (1- 0.3) = 0.15 (0.70) = 0.105 = 10.5%

Component of Costs Amount (₹) Cost of Capital (%) Weight WACC (%)
Equity 21,50,000 21.98 0.81 17.80
Debt 5,00,000 10.50 0.19 2.00
26,50,000 19.80
Comment: At present the company is all equity financed. So, Ke = Ko i.e. 21%.

However, after restructuring, the Ko would be reduced to 19.80% and Ke would

increase from 21% to 21.98%.

Question 26 (RTP May 18)

Company P and Q are identical in all respects including risk factors except

for debt/equity, company P having issued 10% debentures of ₹ 18 lakhs while

company Q is unlevered. Both the companies earn 20% before interest and

taxes on their total assets of ₹ 30 lakhs.

Assuming a tax rate of 50% and capitalization rate of 15% from an all-equity

company.

Required
CALCULATE the value of companies’ P and Q using
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(i) Net Income Approach and

(ii) Net Operating Income Approach.

Answer:

(i) Valuation under Net Income Approach

Particulars P Amount (₹) Q Amount (₹)
Earnings before Interest & Tax (EBIT) 6,00,000 6,00,000
(20% of ₹ 30,00,000)
Less: Interest (10% of ₹ 18,00,000) 1,80,000
Earnings before Tax (EBT) 4,20,000 6,00,000
Less: Tax @ 50% 2,10,000 3,00,000
Earnings after Tax (EAT) 2,10,000 3,00,000
(available to equity holders)
Value of equity (capitalized @ 15%) 14,00,000 20,00,000
(2,10,000 × 100/15) (3,00,000 × 100/15)
Add: Total Value of debt 18,00,000 Nil
Total Value of Company 32,00,000 20,00,000

(ii) Valuation of Companies under Net Operating Income Approach

Particulars P Amount (₹) Q Amount (₹)
Capitalisation of earnings at 15% 20,00,000 20,00,000
 1  0.5 
 
 5 
Less: Value of debt 9,00,000 Nil
{18,00,000 (1 – 0.5)}
Value of equity 11,00,000 20,00,000
Add: Total Value of debt 18,00,000 Nil
Total Value of Company 29,00,000 20,00,000

Question 27 (MTP2 May 23)

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

risk: Capital employed = ₹ 12,00,000, EBIT = ₹ 2,40,000 and Ke = 15%.

Sources Dumble Limited Jumble Limited

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Debt (@12%) 4,00,000 Nil

Equity 8,00,000 12,00,000

An investor is holding 20% shares in the levered company. CALCULATE the

increase in annual earnings of investor if arbitrage process is undertaken.

Also EXPLAIN the arbitrage process if Ke = 20% for Dumbo Ltd instead of

15%.

Answer:

(i) Valuation of Firms

Particulars Dumble Limited Jumble Limited
EBIT 2,40,000 2,40,000
Less: Interest on debt (12% × ₹ 4,00,000) 48,000 Nil
Earnings available to Equity shareholders 1,92,000 2,40,000
Ke 15% 15%
Value of Equity (S) 12,80,000 16,00,000
Debt (D) 4,00,000 Nil
Value of Firm (V) = S + D 16,80,000 16,00,000

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.

(ii) Investment & Borrowings (₹)

Sell shares in Levered company (12,80,000 x 20%) 2,56,000

Borrow money (4,00,000 x 20%) 80,000

Buy shares in Unlevered company 3,36,000

(iii) Change in Return

Income from shares in Unlevered company

(2,40,000 x 3,36,000/16,00,000) 50,400

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Less: Interest on loan (80,000 x 12%) 9,600

Net Income from unlevered firm 40,800

Less: Income from Levered firm (1,92,000 x 20%) 38,400

Incremental Income due to arbitrage 2,400

Arbitrage process if Ke = 20%

(iv) Valuation of Firm

Particulars Dumble Limited Jumble Limited
EBIT 2,40,000 2,40,000
Less: Interest on debt (12% × ₹ 4,00,000) 48,000 Nil

Earnings available to Equity shareholders 1,92,000 2,40,000

Ke 20% 15%
Value of Equity (S) 9,60,000 16,00,000
(Earnings available to Equity shareholders/Ke)
Debt (D) 4,00,000 Nil
Value of Firm (V) = S + D 13,80,000 16,00,000
Value of unlevered company is more than that of levered company. Therefore,

investor will sell his shares in unlevered company and buy proportionate shares

and debt in levered company i.e. 20% share.

(v) Investment & Borrowings

Sell shares in unlevered company (16,00,000 x 20%) 3,20,000

Buy shares in levered company (9,60,000 x 20%) 1,92,000

Buy Debt of levered company 1,28,000

(vi) Change in Return (₹)

Income from shares in levered company 38,400

(1,92,000 x 20%)

Add: Interest on debt of levered (1,28,000 x 12%) 15,360

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Net Income from levered firm 53,760

Less: Income from unlevered firm (2,40,000 x 20%) 48,000

Incremental Income due to arbitrage 5,760

Question 28 (MTP1 Nov 22)

(a) Leo Ltd. has a net operating income of ₹ 21,60,000 and the total

capitalisation of ₹ 120 lakhs. The company is evaluating the options to

introduce debt financing in the capital structure and the following information

is available at various levels of debt value.

Debt Value (₹) Interest Rate (%) Equity Capitalisation Rate (%)
0 N.A. 12.00
10,00,000 7.00 12.50
20,00,000 7.00 13.00
30,00,000 7.50 13.50
40,00,000 7.50 14.00
50,00,000 8.00 15.00
60,00,000 8.50 16.00
70,00,000 9.00 17.00
80,00,000 10.00 20.00
You are required to COMPUTE the equity capitalization rate if MM approach

is followed. Assume that the firm operates in zero tax regime and calculations

to be based on book values.

(b) BRIEF OUT the remedies for Over-Capitalisation.

Answer:

(a) As per MM approach, cost of the capital (Ko) remains constant, and cost of

equity increases linearly with debt.

NOI 21, 60, 000
Value of a Firm = Ko 1,20,00,000 = Ko

21, 60, 000

Ko = 1, 20, 000 = 18%

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D
K  Ko  Kd 
Under MM approach, Ke = E

Statement of equity capitalization under MM approach

Debt Value Equity Value Debt Kd Ko Ko – Kd Ke = Ko

(₹) (₹) Equity (%) (%) (%) +
(Ko –
Kd)
(D/E)
(%)
--- 1,20,00,000 0.0000 N.A. 18.00 18.00 18.00
10,00,000 1,10,00,000 0.0909 7.00 18.00 11.00 19.00
20,00,000 1,00,00,000 0.2000 7.00 18.00 11.00 20.20
30,00,000 90,00,000 0.3333 7.50 18.00 10.50 21.50
40,00,000 80,00,000 0.5000 7.50 18.00 10.50 23.25
50,00,000 70,00,000 0.7143 8.00 18.00 10.00 25.14
60,00,000 60,00,000 1.0000 8.50 18.00 9.50 27.50
70,00,000 50,00,000 1.4000 9.00 18.00 9.00 30.60
80,00,000 40,00,000 2.0000 10.00 18.00 8.00 34.00

(b) Remedies for Over-Capitalisation: Following steps may be adopted to avoid the

negative consequences of over-capitalisation.

(i) Company should go for thorough reorganization.

(ii) Buyback of shares.

(iii) Reduction in claims of debenture-holders and creditors.

(iv) Value of shares may also be reduced. This will result in sufficient funds for

the company to carry out replacement of assets.

Question 29 (MTP2 May 21)

Kee Ltd. and Lee Ltd. are identical in every respect except for capital

structure. Kee Ltd. does not employ debt in its capital structure, whereas

Lee Ltd. employs 12% debentures amounting to ₹ 20 lakhs. Assuming that:

(i) All assumptions of MM model are met;

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(ii) The income tax rate is 30%;

(iii) EBIT is ₹ 5,00,000 and

(iv) The equity capitalization rate of

(v) Kee Ltd. is 25%.

CALCULATE the average value of both the Companies.
Answer:

Kee Ltd. (pure Equity) i.e. unlevered company:

EAT = EBT (1 – t)

= EBIT (1 - 0.3) = ₹ 5,00,000 × 0.7 = ₹ 3,50,000

(Here, EBIT = EBT as there is no debt)

EAT
Value of unlevered company Kee Ltd. = Equity Capitalisation Rate
3, 50, 000
= 25% = ₹ 14,00,000

Lee Ltd. (Equity and Debt) i.e. levered company:

Value of levered company = Value of Equity + Value of Debt

= ₹ 14,00,000 + (₹ 20,00,000 × 0.3)

= ₹ 20,00,000

Question 30 (MTP May 20)

A&R Ltd. is an all equity financed company with a market value of ₹25,000

lakhs and cost of equity (Ke) 18%. The company wants to buyback equity

shares worth ₹5,000 Lakhs by issuing and raising 10% debentures redeemable

at 10% premium after 5 years. Rate of tax may be taken as 35%. Applying

Modigliani-Miller (MM) (with taxes), you are required to CALCULATE after

restructuring:

(i) Market value of A&R Ltd.

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(ii) Cost of Equity (Ke)

(iii) Weighted average cost of capital (using market weights).

Answer:

Value of a company (V) = Value of equity (S) + Value of debt (D)

A&R Ltd. is all equity financed company; its value would equal to value of equity.

Net Income  NI 
Market value of equity = Ke

In the question, market value of equity is ₹25,000 Lakhs and cost of equity (Ke)

is 18%. The Net Income (NI) is calculated as follows:

Net Income  NI  for Equityholders

Ke = Market Value of Equity

Net Income  NI  for Equityholders

0.18 = 25,000 KWH

Net income for equity holders = 4,500 lakh

Net Income (NI) is after tax income, the before tax income would be
4, 500 Lakhs
EBT 1  0.35 = 6,923.07 Lakhs

Since, A&R Ltd. is an all equity financed and there is no interest expense, so here

EBT is equal to EBIT. After issuing 10% debentures, the A&R Ltd would become

a levered company.

(i) The value of A&R Ltd. after issuing debentures would be calculated as

follows:

Value of a levered company (Vg)

= Value of an unlevered company (Vu) + Tax benefit (TB)

= ₹25,000 lakh + (₹5,000 lakh × 35%)

= ₹25,000 + ₹1,750 = ₹26,750

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(ii) Cost of Equity (Ke)

Total Value = ₹26,750 lakh

Less: Value of Debt = ₹ 5,000 lakh

Value of Equity = ₹ 21,750

4, 175 Lakhs
Ke 21, 750 Lakhs = 0,1919 = 19.19%

(iii) WACC (on market value weight

Components of Costs Amount Cost of Capital (%) Weight WACC (%)

(Lakhs)
Equity 21,750 19.19 0.81 15.54
Debt 5,000 8.10 0.19 1.54
26,750 17.08

Working Notes:
1.
All Equity Dent & Equity
EBIT (as calculated above) 6,923.07 6,923.07
Interest to debt-holders --- 500.00
EBT 6,923.07 6,423.07
Taxes (35%) 2,423.07 2,248.07
Income available to equity shareholders 4,500.00 4,175.00
Income to debt holders plus income available to shareholders 4,500.00 4,675.00

2) Cost of Debenture (Kd) =

 5, 500  5, 000 
500 1  0.35   
 5 
 5, 500  5, 000  325  100
 
 2  = 5, 250 = 0.081 or 8.1%

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Question 31 (MTP Nov 19)
A Ltd. and B Ltd. are identical in every respect except capital structure. A

Ltd. does not employ debts in its capital structure whereas B Ltd. employs

12% Debentures amounting to ₹100 lakhs. Assuming that:

(i) All assumptions of M-M model are met;

(ii) Income-tax rate is 30%;

(iii) EBIT is ₹ 25,00,000 and

(iv) The Equity capitalization rate of ‘A' Ltd. is 20%.

CALCULATE the value of & also find out the Weighted Average Cost of

Capital for both the companies.

Answer:

(i) Calculation of Value of ‘A Ltd.’ and ‘B Ltd’ according to MM Hypothesis

Market Value of ‘A Ltd’ (Unlevered)

EBIT 1  t  25, 00, 000 1  0.30 17, 50, 000

Vu = Ke = 20% = 20% =₹ 87,50,000

Market Value of ‘B Ltd.’ (Levered) Vg = Vu + TB

= ₹ 87,50,000 + (₹1,00,00,000 × 0.30)

= ₹ 87,50,000 + ₹30,00,000 = ₹ 1,17,50,000

(ii) Computation of Weighted Average Cost of Capital (WACC)

WACC of ‘A Ltd.’ = 20% (i.e. Ke = Ko)

WACC of ‘B Ltd.’
B Limited (₹)
EBIT 25,00,000
Interest to Debt holders (12,00,000)
EBT 13,00,000
Taxes @ 30% (3,90,000)
Income available to Equity Shareholders 9,10,000
Total Value of Firm 1,17,50,000
Less: Market Value of Debt (1,00,00,000)
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Market Value of Equity 17,50,000

Return on equity (Ke) = 9,10,000 / 17,50,000 0.52

Computation of WACC B. Ltd

Components of Costs Amount Weight Cost of Capital (%) WACC
Equity 17,50,000 0.149 0.52 0.0775
Debt 1,00,00,000 0.851 0.084* 0.0715
Total 1,17,50,000 0.1490
*Kd = 12% (1- 0.3) = 12% × 0.7 = 8.4%; WACC = 14.90%

Question 32 (MTP2 May 19)

The proportion and required return of debt and equity was recorded for a

company with its increased financial leverage as below:

Debt Required Equity Required Weighted Average Cost of

(%) Return (Kd) (%) (%) Return (Ke) (%) Capital (WACC) (Ko)(%)

0 5 100 15 15
20 6 80 16 ?
40 7 60 18 ?
60 10 40 23 ?
80 15 20 35 ?

You are required to complete the table and IDENTIFY which capital structure

is most beneficial for this company. (Based on traditional theory, i.e., capital

structure is relevant).

Answer:

Computation of Weighted Average Cost of Capital (WACC) for each level of

Debt-equity mix.

Debt Required Equity Required Kd× Proportion of debt Weighted

(%) return (%) return + Ke Proportion and Average Cost

(Kd)(%) (Ke) (%) equity

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of Capital

(WACC) (Ko)(%)

0 5 100 15 0%(5%) + 100%(15%) 15

2 6 80 16 20%(6%) + 80%(16%) 14
4 7 60 18 40%(7%) + 60%(18%) 13.6
6 10 40 23 60%(10%) + 40%(23%) 15.2

8 15 20 35 80%(15%) + 20%(35%) 19

The optimum mix is 40% debt and 60% equity, as this will lead to lowest WACC

value i.e., 1 3.6%.

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