CHAPTER 5: CAPITAL STRUCTURE MEANING OF CAPITAL STRUCTURE Capital structure is the combination of capitals from different sources of finance. It is the mix of long term source of funds ie. proportion of debt, equity and preference share capita ¥ The source and quantum of capital is decided on the basis of need of the company and the cost of the capital Capital Structure decision refers to deciding the forms of financing (which sources to be tapped); their actual requirements (amount to be funded) and their relative proportions (mix) in total capitalization Y Capital structure decision will decide weight of debt and equity and ultimately overall cost of capital as well as Value of the firm. So capital structure is relevant in maximizing value of the firm and ‘minimizing overall cost of capital. Note: Capital structure must be distinguished from financial structure. Financial structure represents combination of long term and short term source of funds whereas capital structure includes only the long term source of funds. Therefore, afirm’s capital structure is only a part ofits financial structure, OPTIMUM CAPITAL STRUCTURE Capital structure which maximizes the wealth of firm and minimizes the overall cost of capital Y Optimum Capital Structure deals with the issue of right mix of debt, preference share and equity share capital in the long -term capital structure of a firm. Hence, company should select it appropriate capital structure with due consideration of all factors, MAJOR CONSIDERATION IN CAPITAL STRUCTURE PLANNING The major considerations in Capital Structure Planning are-Risk Cost of capital and Control. ¥-_Ananalysis of the above considerations are given below: ‘Types of fund Risk Cost Control ‘Own funds Low Risk: No question of Most Expensive: Dividend Dilution of control: (Equity) repayment of capital except expectations from equity Since the capital base when the company is under shareholders are higher might be expanded and liquidation. Hence, it is best than interest rates and new shareholders or from the risk point of view preference dividend, public are involved Preference Slightly higher risk than Slightly cheaper as__No dilution of control share capital equity capital. Principal Is compared to equity but because voting rights redeemable after a certain higher than debt. Further, are restricted. period even if dividend preference dividends are payment is based on profits. not tax deductible. Loan funds High Risk: Interest and Cheaper: The Interest rate No dilution of control principal amount of loan is cheaper than the rate of but some institutions must be repaid as per the dividend and also interest. may nominate their agreement irrespective of expense saves taxes. representative in the performance or profits 800 In addition to above considerations, following are the factors that influence capital structure: 1FEATURES OF AN APPROP! a) Financial Leverage (Trading on equity): The use of fixed cost capital increases the EPS as long as the return on investment is greater than the cost of debt and cost of preference share capital. Because of its effects on the earnings per share, financial leverage is one of the Important considerations in planning the capital structure of a company. The companies with high level of EBIT can make profitable use of the high degree of leverage to increase the return on the shareholders equity b) Growth and stability of sales: The capital structure of a firm is highly influenced by the growth and stability of its sale. f the sales of a firm are expected to remain fairly stable, it can raise a higher level of debt. Stability of sales ensures that the firm will not face any difficulty in meeting its fixed commitments. Similarly, the rate of growth in sales also affects the capital structure decision. Usually, greater the rate of growth of sales, greater can be the use of debt in the financing of firm. On the other hand, ifthe sales of a firm are highly fluctuating or declining, it should not employ, as far as possible, debt financing in its capital structure. )_ Flexibility: Flexibility means the firm’s ability to adapt its capital structure to the needs of the changing conditions. Capital structure should be flexible enough to raise additional funds whenever required, without much delay and cost. The capital structure of the firm must be designed in such ‘a way that itis possible to substitute one form of financing for another to economies the use of funds. )_ Legal requirements: The various guidelines issued by the Government from time to time regarding the issue of shares and debentures should be kept in mind while determining the capital structure of a firm. These legal restrictions are very significant as they give a framework within which capital structure decisions should be made. €) Purpose of financing: The purpose for which funds are raised should also be considered while determining the sources of capital structure. If funds are raised for productive purpose, debt capital is appropriate as the Interest can be paid out of profits generated from the investment. But, if it is for unproductive purpose, internal financing should be preferred. 4) Size of the company: Small companies rely heavily on owner's funds while large and widely held companies are generally considered to be less risky by the investors. Such large companies can issue different types of debt instruments or securities 8) Other Considerations: Besides above principles, other factors such as nature of industry, timing of issue and competition in the industry should also be considered. Industries facing severe competition also resort to more equity than debt. \TE CAPITAL STRUCTURE A capital structure will be considered to be appropriate fit possesses following features: y 2) Profitability: ‘The capital structure of the company should be most profitable. The most profitable capital structure Is one that tends to minimize cost of financing and maximize earnings per equity share Solvency: ‘The pattern of capital structure should be so devised as to ensure that the firm does not run the risk of becoming insolvent. Excess use of debt threatens the solvency of the company. 23) Flexibility: ‘The capital structure should be flexible to meet the requirements of changing conditions. Moreover, it should also be possible for the company to provide funds whenever needed to finance its profitable activities. 4) Conservatism: ‘The capital structure should be conservative in the sense that the debt content in the total capital structure does not exceed the limit which the company can bear. In other words, it should be such as is commensurate with the company's ability to generate future cash flows, 5) Control: The capital structure should be so devised that it involves minimum risk of loss of control of the company. PRICE EARNING (P/E) RA’ This ratio indicates the number of times the earning per share is covered by its market price. Y- Itshows the proportionate relation of price per share to earnings per share. Therefore the price per share isthe composite effect of EPS multiplied by P/E ratio, ¥- Itis calculated as follows: Market Price Per Equity Share (MPS) P/E Ratios § Earnings Per Share (EPS) For example, if the market price of an equity share is Rs 20 and earnings per share is Rs 5, the price earnings ratio will be 4 (2,, 20+ 5), This means for every one rupee of earning people are prepared to pay Rs 4. In other words, the rate of return expected by the investors is 25% Significance: P/E Ratio helps the investors in deciding whether to buy or not to buy the shares of a company at a particular price. For Instance, in the example given, if the EPS falls to Rs 3, the market, price of the share should be Rs 12 (ie. 3x4). In case the market price of the share is RS 15, it will not be advisable to purchase the company's shares at that price, HOW TO SELECT BEST CAPITAL MIX Select that alternative which provides maximum price per share with lowest overall cost of capital ¥- If information about computation of market price is not available, then select that alternative which provides maximum EPS. INDIFFERENCE POINT - Itis that evel of E8IT at which EPS under different capital structure will be equal It is also called EPS equivalency point where the firm will be indifferent between two modes of financing. ¥ Itis Computed by solving the equation for EBIT Alternative 1: With Debt ‘Alternative 2: Without Debt (EBIT Interest) (1 ~ Tax Rate EBIT (1 — Tax Rate) No of equity shares No of equity sharesY When both the alternatives in the above chart is equal at a certain level of EBIT (to be computed by solving the above equation), the company is said to be indifferent between the two alternatives. ¥- Ifthe EBIT is more than the indifference level, alternative with debt should be selected to avail the benefits of financial leverage ie., debt financing from the point of view of equity shareholders. However, if the expected EBIT is less than the indifference level, the firm should raise the funds by issuing equity share capital only and avoid the debt financing, Interpretation of the Indifference Point: Situation Option Reason EBIT below Select that alternative EPS is expected to decrease as a result of debt Indifference point which has lower debt. financing EBIT equal to Any alternative can be Both the alternative will have equal EPS indifference point chosen EBIT above Select that alternative Benefits of financial leverage is avallable to indifference point which has higher debt maximize EPS Graphical Presentation of indifference Level Alternative 1: with Debt EPS (RS) ‘Alternative 2: without Debt EDIT (Rs) Indifference E8IT FINANCIAL BREAK EVEN POINT -_BEP = Break Even Point (No Profit, No Loss Point). Financial break-even point is that level of EBIT at which EPS wil be zero. {isthe minimum level of EBIT to satisfy all the fixed financial charges. Y-_Inthis case, EBITis just sufficient to cover interest and Preference dividend. Ifthe EBITis less than the financial breakeven point, then the EPS will be negative but ifthe expected level of EBIT is more than the breakeven point, then more fixed costs financing instruments can be taken in the capital structure, otherwise, equity would be preferred I capital structure consist only equity share capital, financial BEP is equal to zero, capital structure consist equity share capital and debt, financial BEP is equal to interest cost, If capital structure consist equity share capital, preference share capital and debt, financial BEP is equal to [interest cost + preference dividend /(1-tax rate)] ssCAPITAL STRUCTURE THEORIES Capital structure theories explain the theoretical relationship between cost of capital and the value of the firm. There are four capital structure theories viz, Net Income (NI) approach, Net Operating Income (NOI) approach, Traditional approach and Modigliani and Miller (MM) approach, Capital Structure Theories l Relevance Theories lrrelevance Theories LL Net Income (NI) Approach 1. Net Operating (NOI) approach 2._Traditional Approach, 2._ Modigliani & Miller (MIM) Approach | | Capital Structure decision affects the WACC | | Capital structure decision does not affect and value of the firm ‘the WACC and value of the firm { t High Debt—> Low Wacc —> High Firm || High or Low Debt—> WACC—> Firm Value Value Assumptions Underlying the Theories: In order to have @ clear understanding of these theories and the relationship between capital structure and value of the firm or cost of capital, the following assumptions are made: a) There are only two kinds of funds used by a firm ie. debt and equity(No preference shares) bb). The payout ratio is 100%, ie. no retained earnings. ©). The firms total financing remains constant. Only weight of debt and equity can be altered. dd) The firm has perpetual life. @) The business risk is assumed to be constant and independent of capital structure and financial risk, f} Cost of debt (Ka) is less than (Ke). a) The operating profits ofthe firm are given and are not expected to grow. (Constant E81) b) Value of the firm can be determined by capitalizing net operating profits with overall capitalization rate, In analyzing the capital structure theories the following basic definitions are used: a) E= Market value of Equity shares b)_D=Market value of debt ©) V= S+D=Market value of the firm dd) NOI= Expected net operating income, Le., Earnings before interest and taxes (EBIT) fe) NI=NOI-Interest = Net Income or shareholders earning. 5NET INCOME (NI) APPROACH Suggested by David Durand, This theory is subject to the following assumptions: a) The cost of debt (ka) is cheaper than cost of equity (ke) and they remain constant irrespective of the degree of leverage (ie. irrespective of debt equity mix) b) This theory believes that use of more debt does not change the risk perception of equity Investors. c) There are no corporate taxes, Y- Therefore, if more debt capital is used in capital structure, the overall cost of capital declines because ofits relative cheapness and the value of the firm increases. Y Graphical presentation: y * Cost of capital Cost of Equity Overall cost of capital Cost of Debt Ly Degree of leverage (Weight of Leverage) ¥ Its evident from the above diagram that when degree of leverage is zero (ie. no debt capital employed), overall cost of capital is equal to cost of equity (Ko = Ke). If debt capital is employed further and further, which is relatively cheap when compared to cost of equity, the overall cost of capital declines and it becomes equal to cast of debt (kd) when the firm is fully debt financed, ¥ Computation: Step 1: Compute Market Value of Equity (E) = Net income (EBT) /Cost of Equity (Ke) Step 2: Compute Market Value of Debt (D) = Interest/Cost of Debt (K.) Step 3: Compute Market Value of Firm (V) = Market Value of Debt (0) + Market Value of Equity (E) OR, Market Value of Firm (V) =Operating Income (EBIT}/Overall cost (Ke) TRADITIONAL APPROACH According to this approach, cost of capital can be reduced or the value of the firm can be increased with a judicious mix of debt and equity This theory says that cost of capital declines with increase in debt capital up to a reasonable level and later it increases with a further rise in debt capital The way in which the overall cost of capital reacts to changes in capital structure can be divided into three stages under traditional position. Stage! In this stage, the cost of equity (K e) and the cost of debt (Kd) are constant and cost of debt is less than cost of equity. The employment of debt capital up to a reasonable level will cause the overall cost of capital to decline due to the low cost advantage of debt. Stage! Y Once the firm has reached a reasonable level of leverage, a further increase in debt will have no effect on the value of the firm and the cost of capital. This is because of the fact that a further rise in 6debt capital increases the risk to equity shareholders which leads to a rise in equity capitalisation rate (ke). This rise in cost of equity exactly offsets the low ~ cost advantage of debt capital so that the overall cost of capital remains constant. Stage Il Ifthe firm increases debt capital further and further beyond reasonable level, it wll cause an increase in risk to both equity shareholders and debt — holders, because of which bath cost of equity and cost of debt start rising in this stage. This will in turn cause an increase in overall cost of capital Y Ifthe overall effect of all the three stages is taken, itis evident that cost of capital declines and the value of the firm increase with a rise in debt capital up to a certain reasonable level. If debt capital is further increased beyond this level, the overall cost of capital (Ko) tends to rise and as a result the vvalue of the firm will decline. Y- Graphical presentation: on Cost of Capital (Rs) ‘Cost of Equity (Ke) ce Overall cost of capital (Ks) cost of Debt (ka) ox c u Degree of Leverage ¥- Itis evident from above graph that the overall cost of capital declines with an increase in leverage up to point L and it increases with rise in the leverage after point L1. Hence, the optimum capital structure lies in between Land Li NET OPERATING INCOME (NO!) APPROACH ¥-Asperthis approach, capital structure and value of the frm are irrelevant. Cost of debt (Ka) remains constant at various levels of debt-equity mix ¥ This theory believes that equity share holders are proportionately affected by higher weight of debt in capital structure. Cost of debt is cheaper than cost of equity but if the firm uses more debt, equity shareholders expect more due to higher financial risk. Asa result, the low cost advantage of debt is exactly offset by the increase in the equity capitalisation rate. Thus, the overall capitalisation rate (Ko) remains constant and consequently the value of the firm does not change. Therefore, every debt-equity mixis as good as any other mix Hence, value of levered firm willbe equal to value of unlevered firm. ¥ Computation: Step-1: Compute Value of Firm (V) = Operating income {EBIT)/Overall cost (Ko) Step -2: Compute Market Value of Debt (0) == Interest/Cost of Debt (Ka) Step-3: Compute Market Value of Equity (E) = Value of Firm (V}- Value of Debt (0) Step- 4: Compute Cost of Equity (ke)= Net income (EBT)/ Value of Equity(E) Graphical presentation:y Cost of Eauity(K:) Overall Cost of Capital (Ke) Cost of Capital (Rs) Cost of Debt (Ks) x L__ Degree of Leverage The above diagram shows that Ko and Kd are constant and Ke increases with leverage continuously. ‘The increase in cost of equity (Ke) exactly offsets the advantage of low cost debt, so that overall cost of capital (Ko) remains constant, at every degree of leverage. It implies that every capital structure is ‘optimum and there is no unique optimum capital structure. MODIGLIANI AND MILLER APPROAC! The Modigliani and Miller approach is identical with the Net Operating Income Approach. Y Modigliani and Miller argued that, the overall cast of capital (Ko) and the value of the firm are not affected by the changes in capital structure. In other words, capital structure decisions are irrelevant and value of the firm is independent of debt — equity mix. The financial risk increases with more debt content in the capital structure. As a result cost of equity (ke) increases in @ manner to offset exactly the low ~ cost advantage of debt. Hence, overall cost of capital remains the same, ¥- Itprovides operational justification for irelevance of capital structure by explaining arbitrage process Until equilibrium position is re-stored. The ultimate theorem is that value of levered firm is equal to value of unlevered firm. Assumptions of the MIM Approach: a) There isa perfect capital market: bb) Capital markets are perfect when Investors are free to buy and sell securities, , They behave rationally, and they are well informed, )_ Investors can borrow funds without restriction at the same terms as the firms do, d)_ There are no transaction costs. } Firms can be classified into homogeneous risk classes. All the firms in the same risk class will have the same degree of financial risk f)_Allinvestors have the same expectation of a firm's net operating income (EBIT). 8) The dividend payout ratio is 100%, which means there are no retained earnings. hh). There are no corporate taxes. a) Arbitrage Process: a) According to M -M, two firms identical in all respects except their capital structure cannot have different market values or different cost of capital. 8bb) In case, these firms have different market values, the arbitrage will take place and equilibrium in market values is restored, Arbitrage process refers to switching of investment from one firm to another. When market values are different, the investors will try to take advantage of it by selling their securities with high market price and buying the securities with low market price. ©) Because of this arbitrage process, the market price of securities in higher valued market will come down and the market price of securities in the lower valued market will go up, and this switching process is continued until the equilibrium is established in the market values. So, M ~ M, argue that there is no possibility of different market values for identical firms. The arbitrage will be: Case 1: Switching from Levered firm to unlevered firm: Step-1: Sel all the shares at market value and realize the amount. ‘tep-2: Borrow personal loan in proportion of the shareholding in levered firm. Step-3: Purchase the share of unlevered firm. The investor may spend all the available funds to purchase shares of unlevered firm and in that case his future income will be more than the previous income or alternatively he may purchase equal percentage of shares in unlevered firm (equal to percentage of shareholding in levered firm) which makes his future income equal to previous income and saves cash Case 2: Switching from Unlevered firm to Levered firm: ‘Step-1: sella shares at market value and realize the amount. Step-2: Purchase shares and debentures both in levered firm. He may spend all the funds in the proportion of market value of debt and equity in the levered firm and in that case his future income will be more than the previous income or alternatively he may purchase debt and equity In levered firm in equal percentage of shareholding at unlevered firm which makes his future income equal to previous income and saves cash Note: The arbitrage process is temporary and because of demand and supply rule, value of both the firms will be equal in ong run. M~M approach with Corporate Taxes: b) Modigliani and Miller later recognized the importance of the existence of corporate taxes. ‘Accordingly, they agreed that the value of the firm will increase or the cost of capital will decrease With the use of debt due to tax deductibility of interest charges. Thus, the optimum capital structure can be achieved by maximizing debt component in the capital structure. According to this approach, value ofa firm can be calculated as follows: Net Income (EAT) Value of Unlevered firm (Vu) = Overall cost of capital (K.) Value of levered firm (Vi) = Value of Unlevered firm + Debt (tax rate)PROBLEMS: ‘Question No-1: ‘A company’s capital structure consists of the following: Equity shares of Rs 100 each Rs 2000,000 Retained Earnings Rs 1000,000 19% Preference Shares Rs 1200,000 7% Debentures Rs 800,000 Its existing EBIT is Rs 600,000 and the relation of €8IT and Capital employed is likely to remain unchanged after expansion. The expansion involves additional finances of Rs 25 Lakhs for which following alternatives are available to it I) Issue of 20,000 equity shares at a premium of Rs 25 per share ii) Issue of 10% Preference shares Ii) Issue of 8% debentures It is estimated that P/E ratio in the case of equity shares, preference shares and debentures financing would be 21.4, 17 and 15.7 respectively. Which of these alternatives of financing would you recommended and why? The income tax rate is 50%. Solution: Existing Capital Structure = 50, 00,000 Proposed Capital Structure = 50, 00,000 + 25, 00,000 = 7, 00,000 Existing EBIT = 600,000 Existing ROCE = 600,000/50, 00,000 = 12% ion of financing alternat Particulars Existing (Rs) | Plan (Rs) Plan ti(Rs) Plan Iii(Rs) ear 600,000 | 900,000 [900,000 | 900,000 Less interest 56,000 36,000 36,000 756,000 ear 3aa,00 | 848,000 | 84a,000 | 644,000 less Tax 772,000 | 422,000 | 422,000 | 322,000 eat 77,000 | 422,000 | a¥2,000 | 322,000) less Preference Dwidend | 108,000 | 108,000 | 358,000 | 108,000, Earnings for equity shares | 164,000 314,000 4,000 214,000 | No of equity shares 20,000 40,000 20,000 20,000 | 5 785 32 107 PE Ratio. za 7 157 MPs 16758 54.40 16738 Decision: Plan i Reason: Highest ES as well as Market pice Question No-2: ‘A company earns @ profit of Rs 300,000 pa. after meeting its interest liability of Rs 120,000 on 12% debentures. The no. of equity shares of Rs 10 each are 80,000 and the retained earnings amount to Rs 1200,000. The company proposes to take up an expansion scheme for which a sum of Rs 400,000 is required. 10I is anticipated that after expansion, the company will be able to achieve 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. Assume tax rate Is 50% 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 li, Advice the company as to which source of finance i preferable. Solution: Existing Capital Structure = 30, 00,000 (Debenture = 10, 00,000, Equity shares = 800,000 and Retained earnings =12, 00,000) Proposed Capital Structure = 30, 00,000 + 4, 00,000 = 34, 00,000, Existing EBIT = 420,000 (300,000 + 120,000) Existing ROCE = 420,000/30, 00,000 = 14% Evaluation of financing alternat Particulars: Plan I: Debt (Rs) Plan I Equity (Rs) err 476,000 476,000 Less: Interest 168,000 T 120,000 eer 308,000 356,000 Less: Tax 154,000 178,000 EAT 154,000 i 178,000 Less: Preference Dividend 7 T = Earnings for equity shares 154,000 178,000 No of equity shares 80,000 120,000 EPS 1.925 1.483 Decision Plan ‘Question No-3: Anew project under consideration requires a capital outlay of Rs 300 Lakhs. The required funds can be raised either fully by equity shares of Rs 100 each or by equity shares of the value of Rs 200 Lakhs and by loan of Rs 100 lakhs at 15% interest. Assuming a tax rate of 50%, calculate the figure of profit, before tax that would keep the equity investors indifferent to the two options. Verify your answer by calculating the EPs, Solution: Option-1: Raise 300 lakhs by issuing equity shares, number of shares =300,000 Option-2: Raise 200 lakhs by issuing equity shares, number of shares = 200,000 and raise 100 lakhs from loan @15% Figure of profit before tax (EBIT) that keeps equity investors indifferent will be indifference point which is calculated as follows: Alternative 1: Without Debt Alternative 2: With Debt EBIT (1 ~Tax Rate} No of equity shares No of equity shares Or, EBITxO.S = (EBIT=15,00,000)x0.5 300,000 200,000 Or, EBIT=45, 00,000 uVerification statement: Particulars Option-1: without debt Option-1: with debt EBT “45, 00,000 45, 00,000 Less: Interest = 45, 00,000 EST “45, 00,000 '30, 00,000 Less: Tax 22,50,000 15, 00,000 EAT 22,50,000 15, 00,000 Divide: No of shares 300,000 200,000 EPS R75, R75 ‘Question No-4: EXE Ltd. is considering three financing plans. The key information is as follows: a, Total investment to be raised Rs 200,000,000 and expected PBIT is Rs 80,000,000 Plans of financing proportion Plans Equity Debt Preference Shares A 100% S 8 50%6 c 50% & Cost of debt (pretax cost) 12% 4. Dividend of Preference shares o% e. TaxRate 35% f. Equity shares of the face value of Rs 10 each will be issued at a premium of Rs 10 Determine for each plan- |. Earnings Per Share (EPS) and the financial break-even point ii. Indifference points financial plans A and B and A and C Solution: Proposed Capital Structure = 20 Crores, Evaluation of financing alternatives Particulars Plan A (Rs in| Plan B (Rs in| Plan C(Rs in Crores) Crores) Crores) EIT & 8 8 Less: Interest 12 = esr 8 68 Less: Tax 28 238 EAT 52 aaz less: Preference Dividend | - - Earnings for equity shares | 5.2 aaz No of equity shares Fy Os EPS 52 aaa Financial BEP ° 12 (no fixed | (equal to interest financing cost) | cost) Indifference Point Between Plan A and B: EBIT (1 Tax Rate) = (EBIT- Interest) 1 —Tax Rate) No of equity shares No of equity shares 2EIT = (BiT—12)x0.65 1 os, Hence, EBIT = 2.4 Crores Between Plan A and C: EBIT (1 Tax Rate) EBIT (1 Tax Rate) -PO No of equity shares No of equity shares EBITxO.65 = (EBITx0.65)-0.9 1 Os, Hence, EBIT = 2.769 Crores ‘Question No 5: (CAP-II, Dec-19, 8 Marks) ‘The following figures are made available to you: Re Net profit for the year 1,800,000, less: Interest on secured debentures at 15% pa, 112,500 (Debentures were issued 3 months after the commencement of the year) Earnings before tax 1,687,500 less: Income tax at 35% and Dividend Tax 843,750, Profit after tax 843,750 Number of equity shares (Rs. 10 each) 100,000 “Market quotation of equity share Rs, 109.70 ‘The company has accumulated revenue reserves of Rs. 1.2 million. It is examining a project calling for an Investment obligation of Rs. 1 million. This investment is expected to earn the same rate of return as funds already employed. You are informed that a debt equity ratio (Debt divided by debt plus equity) higher than 60% will cause the price earnings ratio to come down by 25% and the interest rate on additional borrowings will cost company 300 basis points more than on the current borrowings on secured debentures. Required: ‘Advice the company on the probable price of the equity share, if i. The additional investment were to be raised by way of loans; or li, The additional investment were to be raised by way of equity. Make valid assumption wherever necessary. Solution: Working Note: Present earning/share (EPS): Rs. Profit before taxes 1,687,500 Less: Taxes at 35% (590,625) Profit after tax 1,096,875 No. of equity shares 100,000 EPS. Rs, 10.97 Market Price Rs, 109.70 Hence, P/E ratio = 109.70/10.97 = 10 times 3“ Probable Price/share, ifthe additional investment were to be raised by way of loans Present capital employed: Rs. Equity 1,000,000 Debenture (Long term) 41,000,000. {(112,500%12/9)+0.15) Revenue reserves 1,200,000 Rs. 3,200,000 Pre-interest and pre-tax profits given Rs. 1,800,000 Rate of return = 1,800,000/3,200,000%100 = 56.25% Debt equity ratio, if Rs, 1 million were to be borrowed (Debt Rs. Since, the debt equity ratio will not exceed 60% P/E will remain IF Rs. 1 million is to be borrowed, the earning will be as under: 20 same. Rs, Rs. Return of 56.25% on Rs. 4.2 million 23,62,500 Less: Interest at 15% on existing Rs. 1 million debentures, 150,000 Interest on fresh borrowed amount of Rs. 1 million at 18% 180,000 330,000 Profit ater interest before tax 2,032,500 Less: Tax at 35% 74375 Profit after tax 1,321,125 No. of equity shares 100,000 EPS Rs 13.21 Probable price of equity share = Rs. 13.21 x 10 = Rs. 132.10 (i) Probable Price/share, if additional investment were to be raised by way of equity IF Rs, 1 million were to be raised by way of equity shares to be raised at market rates, The existing market price of Rs. 109.70 may come down a little and may possibly settle at Rs. 100. Hence, new equity shares to be raised willbe: Rs, 1,000,000 /Rs. 100 = 10,000 shares IF Rs. 1 million is to be raised by way of equity shares, the earning will be as under: Rs Profit before interest and tax 2,362,500 Less: Interest on debentures 150,000 Profit after interest before tax 2,212,500 Less: Tax @ 35% 774.375 Profit after tax 1,438,125 No. of equity shares 110,000 EPS Rs 13.07 Probable price of equity share = Rs, 13.07 x1 Question No-6: (CAP-II, Dec-09, 946 = 15 Marks) ‘A steel! manufacturing company is planning to expand its assets by 50%. All financing for this expansion will come from external sources, The expansion will generate additional sales of Rs. 6 million with a return of 20% on sales before interest and taxes. ‘The finance department of the company has submitted the following plan for the consideration of the Board of Directors. 14Plan 1: Issue of 12.596 debentures. Plan 2: Issue of 12.5% debentures for half the required amount and balance in equity shares to be Issued at 20% premium, Plan 3: Issue equity shares at 20% premium. ‘The Balance Sheet and Income Statement of the company as on 30" Ashadh is as given below: Balance Sheet of the Company as on Ashadh 2056 Liabilities ‘Amount Assets Amount Equity Capital (Rs. 100 per share) Rs. 8,000,000 Total Assets, Rs. 24,000,000 10% Debentures 6,000,000 Retained Earnings 4,000,000 Current Liabilities 6,000,000 24,000,000 _24,000,000 Income Statement for the year ending on Ashadh 2066 Sales Rs, 380, 00,000 Operating Costs 32,000,000 Earnings before Interest and Taxes (EBIT) 6,000,000 Interest 500,000 Earnings before Tax (EBT) 5,400,000 Taxes 1,830,000 Earnings after Tax (EAT) 3,510,000, Earnings per Share (EPS) 43.875 Based on the above data and information, you are required to calculate: a, Indifference points between (i) Plan 1 and 2, (i) Plan 1 and 3, and (iil) Plan 2 and 3. . Expected market price of the shares in each of the situations on the assumption that the price learnings ratio is expected to remain unchanged at 12 if plan 3 is adopted, but is likely to drop to 9 if either plan 1 or 2s used to finance the expansion. Solution: Preliminary Computations: Number of Equity Share to be issued under Plan 3 = Rs, 12,000,000/Rs. 121 12.5% Debentures to be issued under Plan 2 = $0% of Rs. 24,000,000 X 0.5 = Rs. 6,000,000 4a) Indifference Point among different Finance Pla Between Plans 1 and 2: [(X= Interest) ({1=t)] / NA = [(X= Interest) ((1~t)] /N2 Where, EBIT at the indifferent point N1=_ Number of equity shares under Plan 1 N2= Number of equity shares under Plan 2 Corporate income tax rate Substituting the values, we get (X 2100, 000) 0.65] = [{X~1350, 000) 0.65} 80,000 130,000 r, 13 (X-2,100,000) = 8 (x —1,350,000) r, 13 X~27,300,000 = 8 X~ 10,800,000 r, 5 X= 27,300,000 ~ 10,800,000 = 16,500,000, ‘Therefore X = Rs. 3,300,000 15Between Plans 1 and 3: (X 2,100,000} 0.65] = [(X - 600,000) 0.651 0,000 180,000 0, 18 (X ~2,100,000) = 8 (x ~ 600,000) r, 18 X~37,800,000 = 8 X- 4,800,000 Or, 10 X = 33,000,000, Therefore X = Rs. 3,300,000 Between Plan 2 and 3: {(X=1,350,000) 0.65] = [(X-600,000} 0.65] 130,000 180,000 Or, 18 (X-1,350,000) = 13 (x - 600,000) Or, 18 X~24,300,000 = 13 X 7,800,000 Or, 5 x= 16,500,000, ‘Therefore x = Rs, 3,300,000 b) Determination of Market Price per Share under Various Alternative Plans: Particulars Plan (Rs) lan i (Rs) Plan (Rs) esi 7,200,000 7,200,000 7,200,000 less: Interest 21,00,000 413,50,000 {600,000 est 5,00,000 '58,50,000 {66,00,000 ess: Tax 17,85,000, 20,47,500 310,000 EAT 33,15,000 38,02,500 42,90,000 Less: Preference Dividend : - Earnings for equity shares 33,15,000 38,02,500 42,90,000 ‘No of equity shares 80,000 130,000 180,000 EPS 41.4375, 29.25 73.833 PE Ratio 9 9 R MPS 372.94 263.25 286 * Existing EBIT Rs. 6,000,000 + EBIT on Additional Sales of Rs. 6,000,000 (0.20 X 6,000,000) = Rs. 7,200,000 Question No 7: (CAP-II,June-09, 84242 = 12 Marks) DEF Ltd. plans to expand assets by 60%. To finance the expansion, it has a choice between a straight 9% debt issue and equity issue. Its current balance sheet and income statement are as shown below: Balance Sheet of DEF Ltd. as on 32 Ashad 5% Debt Rs, 1,000,000 Total Assets §,000,000 Equity Shares (Rs. 100 per share) 2,500,000 Retained Earnings 4,500,000 5,000,000 5,000,000 16Income Statement for the year ended on 32 Ashad. sales Rs. 15,000,000 Total cost (excluding interest) 13,450,000 Earnings before interest and Taxes (EBIT) 1,350,000 Less: Interest on Debt 50,000 Earnings before Tax (EBT) 41,500,000 Less: Taxes 450,000 Net Income 31,050,000 If the company finances the proposed expansion with debt, the rate on the incremental debt will be 9% and the price/earnings ratio of the equity shares will be 10. if expansion is financed by equity, the new shares can be sold at Rs. 300 and the P-E ratio of all the outstanding equity shares will remain 12. Considering all the information given above, you are required to de the following: a) Assuming that net income before interest of debt and taxed (EBIT) is 10% on sales, calculate EPS at assumed sales of Rs. 10 million, Rs. 20 million and Rs, 25 million under the alternative mode of financing the expansion program (assume no fixed costs. b) Using the price/earnings ratio indicated, calculated the market value of equity share for each sales level for both the debt and equity methods of financing, c)_ If the firm follows the policy seeking to maximize the price of its shares, which form of financing should be employed? Solution: Statement showing computation of Market Price sin Sales level 10 Million 20 Million 25 Million Debt | Equity | Debt | Equity | Debt | Equity fair 1 1 2 2 25 25 Less: Interest | 032 005 ox 005 0x2 0.05 EBT 068 035 1.68 195 218 245 | UessiTax30% | 0204 | 0285 | 0504 | oses | O44 | 0735 tat oa7é | ses | 1176 | 135 | 16 | 175 | No-ofshares | 0.025 | 0035 | 0025 | 0035 | 0.025 | 0.035 5 19.08 9 a7.04 39 61.08 | PE 10 2 10 2 10 2 mrs | Aei90a | Reve | a70a | Aeass | c10a | Aesee | Decision: The answer will depend on the expected level of ales the sales evel is at WAS, 10 milion, equity form of nancing should be employed ast will have better MPS. A the sles level of NRS. 20 milion and NR, 25 milion, MPS under debt form of nancing sto be preferred for higher MPS as compared to equity mode of financing, ‘Working Notes: ‘© _Indebt financing, the number of equity shares outstanding = 2,500,0000 / 100 = 25,000 ‘© Inthe case of equity financing, the total number of outstanding shares will be as computed below: Additional equity to be raised = 0.60 X 5,000,000 = NRs. 3,000,000 Price per share at which shares can be sold: NRs. 300 ‘Additional Number of shares = NRs. 3,000,000/NRs. 300 = 10,000 ‘Total Number of Shares = Existing shares + new shares = 25,000 + 10,000 ”{Question No 8: (IPCC, May 2011, ICAI) ‘The management of Z Ltd. wants to raise its funds from market to meet out the financial demands ofits long-term projects. The company has various combinations of proposals to raise its funds. You are given the following proposals of the company: (i) Proposals WofEquity — %of Debts, ‘of Preference shares P 100 : : Q 50 50 . R 50 c 50 (i) Cost of debt 10% (ii) Cost of preference shares ~ 10% (iv) Tax rate ~ 50% (v) Equity shares of the face value of Rs 10 each willbe issued at a premium of Rs 10 per share, (ui) Total investment to be raised Rs 40, 00,000. (vii) Expected earnings before interest and tax Rs 18, 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. Also indicate if any of the plans dominate, Solution: Statement showing computation of EPS Particulars Plan P (Rs) Plan Q (Rs) Plan R (Rs) eer 11800,000, 11800,000, 11800,000 Less: Interest 200,000 esr 180,000 160,000 1800,000 Tess: Tax ‘900,000 | 800,000 ‘900,000 EAT ‘900,000 | 800,000 ‘900,000 Less: Preference Dividend : : 200,000 Earnings for equity shares 900,000 | 800,000 700,000 ‘No of equity shares 200,000 100,000 300,000 EPS a5 a 7 Financial BEP 0 200,000 ‘400,000 Indifference Point ‘Between Plan P and Q: EBIT (1 —Tax Rate) = No of equity shares BIT Int (1 ~Tax Rate! ‘No of equity shares EBITxO.S = (EBIT-200,000)x0.5 200,000 100,000 Hence, EIT = Rs 400,000 ‘Between Plan P and R: EBIT (1 ~Tax Rate) = No of equity shares EBITxOS = (EBITx05)-200,000 200,000 100,000 Hence, EBIT = Rs 800,000 EBIT{A —Tax Rate)- PD No of equity shares‘Between Plan Qand R: (EBIT — Int) (1 ~ Tax Rate) = EBIT(—Tax Rate)- PD No of equity shares No of equity shares (EBIT-200,000) x0.5 (€BITx0.5)- 200,000 100,000 100,000 Hence, EBITis not possible Decision: Plan Qis a dominating plan as its EPS is the maximum at the expected level of EBIT ‘Question No-9: JP Motors, a producer of turbine generators, isin the following situation: EBIT= Rs 4 Million; Tax rate=35%, Debt outstanding= Rs 2 Miilion, Cost of equity=15%. No of Shares outstanding=600,000 and book value per share= R10, Since JP's product market is stable and the company expects no growth, all earnings are paid out as dividends. a, What are JP's Earnings per Share (EPS) and its Price per share (PI? b. JP can increase its debt by Rs 8 Million to a total of 10 Million, using the new debt to buy back and retire some of its shares at the current market price and its interest rate on debt will be 12%. It will have to call and refund the old debt by further borrowing at 12% interest rate. And its cost of equity will rise from 15% to 17%. EBIT will remain constant. Should JP change its capital structure? Solution: ‘Statement showing Computation of Price per share: Particulars “Amount EIT 40, 00,000 Less: Interest 2,00,000 est 338, 00,000 Less: Tax 13,30,000 EAT 24,70,000 Divide: No of shares 600,000 EPS. Read Cost of Equity 15% Price per share (Po) = EPS/Ke Rs 27.87 Statement showing Computation of Price per share in change situation: Particulars ‘Amount EIT 40, 00,000 Less: Interest 12,00,000 EST 28, 00,000 Less: Tax '9,80,000 EAT 18,20,000 Divide: No of shares 308773 EPS, RS5.89 Cost of Equity 17% Price per share (Po) = EPS/Ke Rs 38.65, 19Decision: Since EPS and MPS both increases from existing level, itis recommended to revise capital structure. ‘Working Notes: 1) Number of shares bought back = 8 Million/Rs 27.47 = 291,227 shares 2) Hence, Number of remaining shares after buy back = 600,000 - 291227 = 308,773 shares 3) Since 100% pay-out ratio, Ke = EPS/ Po, Or, Po= EPS/Ke ‘Question No-10: ‘A new project is under consideration in Zip Ltd, which requires a capital investment of Rs 4.5 Crores. Interest on term loan is 12% and corporate tax rate is 50%. If the debt equity ratio insisted by the financing agencies is 2:1, calculate the point of indifference for the project. Sol Ifthe debt equity ratio insisted by the financing agencies is 2:1, the company has two options: Option-1: Either arrange total required fund of Rs 4.5 Crores from equity shares only, or Option-2: Arrange Rs 3 Crores of required fund from debt @12% and balance of Rs 1.5 Crores from equity shares, so that debt equity ratio becomes 2:1 Now, assuming face value per share is Rs 10, indifference point can be calculated as follows: EBIT (1 Tax Rate) EBIT- Int (1 ~Tax Rate No of equity shares No of equity shares EBITxO.S EBIT- 0.36) x0.5 04S Crores 0.15 Crores Hence, EBIT = Rs 0.54 Crores. Question No-11: Existing capital structure of XYZ Ltd is as follows: (Rs in Crores) Paid up share capital of Rs 10 each 10 Reserves and surplus 15 Debentures bearing 14% interest per year 15 40 ‘An expansion program for the company is under contemplation. It requires Rs 20 Crores and promises an increase of Rs 6 Crores in the EBIT from its existing level of Rs 8 Crores. ‘Three financing alternatives for obtaining the requisite amount of Rs 20 Crores are under consideration. ‘The first alternative is to issue equity shares of Rs 10 par at a premium of Rs 40 each. Share issue expenses as also underpricing of the issue in comparison to ruling market price result in net proceeds of Rs 40 for every new share issued. ‘The second alternative is to borrow the requisite amount at 15% rate of interest per year. ‘The third alternative is a combination of the frst and second, under which Rs 10 Crores will be borrowed at 15% rate of interest per year and the balance amount obtained by share issue as per terms indicated in the first alternative, Applicable corporate income tax ate is 40% Required: a. The expansion program is to be considered only ifthe EPS increases from its existing level. Indicate whether the program qualifies for consideration. b. At what level of EBIT will EPS be equal to zero under each of the financing alternatives? Determine the points of indifference among the 3 financing alternatives and the corresponding EPS 20Solution: ‘Statement showing calculation of EPS (Rs in Crores) Particulars Existing (Rs) | Plani(Rs) | Plan ti(Rs) | Plan (Rs) EsiT & um ry 4 Less: Interest 2a 2a 5a 36 esr 53 19 33 10.4 ess: Tax 236 476 356 416 EAT 354 744 534 624 Divide: No of shares 1 15 1 1.25 EPS Resa Rs 4.76 Rs5.34 54.992 Financial BEP 2acrores | 2Crores | 51Grores | 3.6Crores Indifference Point Between Plan! and I: (€BIT=Int) (1—Tax Rate] = (€BIT- Int) (1 ~Tax Rate] No of equity shares No of equity shares EBIT-2.1)x0.6 = (EBIT-5.1)x0.5 15 1 Hence, EBIT = Rs 11.1 Crores Between Plan It and ll (EBIT=Int) (1—Tox Rate] = — (EBIT- Int) (1 —Tax Rate] No of equity shares No of equity shares EBIT-5.1)x0.6 = (EBIT-3.6) x0.6 d 1.25 Hence, EBIT = Rs 11.1 Crores Between Plan | and I (EBIT=Int) (1=Tox Rate] = (EBIT- Int) (1 —Tax Rate! No of equity shares No of equity shares EBIT-2.1)x0.6 = (EBIT-3.6)x0.5 15 1.25 Hence, EBIT = Rs 11.1 Crores Decision: Since EPS will increase if expansion is made, the programs are qualified for expansion. ‘Working Notes: 41). Existing number of shares = 1 Crores. 2). Number of shares (Plan-I) = Existing shares + New shares = 1 + 20 Cr/Rs 40 per share= 1.5 Crores (Even if shares are issued at Rs 50 per share, net proceeds is only Rs 40 per share because of issue expenses. Hence, number of shares is based on Rs 40 per share) 3). Number of share (Plan-lI)= 1 Cr only (no new issue of shares) 4) Number of share (Plan-Il) = 1 Cr + 10Cr/Rs 40 per share = 1.25 Crores. aQuestion No-12: ‘AB Ltd, provides you the following figures: Rs sir 300,000 Less: Interest @12% 60,000 esr 240,000 Tax @ 50% 120,000 EAT 120,000 No. of Equity Shares (Rs 10 each) 40,000 Ruling Price in Market 30 P/E Ratio 10 ‘The company has undistributed reserves of Rs 600,000, The company needs Rs 200,000 for expansion. This amount will earn at the same rate as funds already employed. You are informed that debt equity ratio (debt divided by debt plus equity) higher than 35% will push the P/E ratio down to 8 times. The interest rate on additional amount borrowed will be 14%. You are required to ascertain the probable price of the share: |. lthe additional funds are raised as debt, and ii. the amount is raised by issuing equity shares. Solution: Statement showing probable Market Price of the share: Particulars Plan i:Debt (Rs) Plan tl Equity (Rs) sir 340,000 340,000 Less: Interest 88,000 60,000 EST 252,000 280,000 Less: Tax 126,000 140,000 EAT 126,000 1140000 Less: Preference Dividend : 7 Earnings for equity shares 126,000 140/000 No of equity shares 40,000 45,667 EPS 315 3 PE Ratio a 10 MPS RS 25.2 Rs30 41) Existing Capital Employed: Equity share capital + Reserves + Loan @ 12% = 40,000 x 10 + 600,000 + 60,000/0.12 = 400,000 + 600,000 +500,000 = 15,00,000 2) Existing ROCE = EBIT/Capital Employed = 300,000/15,00,000 = 20% 3) Proposed Capital Employed: Existing Capital Employed + Expansion = 17,00,000 44) Proposed EBIT = 17,00,000 x 20% = 340,000 5) If funds are raised through debt, total debt = $00,000 + 200,000 = 700,000. 6) Hence proposed Debt-Equity Ratio = 700,000/17, 00,000 = 41.18%, which is more than 35% Hence, PE ratio will be times. 7) Number of new shares if fund is collected through equity = Required Amount/ Market Price = 200,000/30 = 6,667 shares, 2‘Question No-13: (CAP-II,July-15, 8 + 1= 9 Marks) ‘The following information pertains to Rajaram Ltd. for the year ending Ashadh end, 2071; Rs. in millions) ert 30.00 Less: Interest on Debs (at 1234) 5.00 Par 24.00 Less: Tax @ 25% 6.00 PAT 18.00 Undistributed reserves 60.00 No. of outstanding shares of Rs. 10 each 40 Lakh Ps Rs. 3.00 Market price ofthe share Rs, 30.00 P/E Ratio 10.00 ‘The company requires Rs. 20 million for expansion which is expected to earn the same rate as earned by the present capital employed. If the debt to capital employed ratio is higher than 35%, the P/E ratio is expected to decline to 8 and the cost of additional debt will ise to 14%, Requires (i) Calculate the probable share price of Rajaram Ltd, 4) If the required amount is raised through debt, and b) Ifthe required amount is raised through equity and the new share is issued at Rs. 25 per share. (i) What option would you recommend to raise the required amount of funds ta the company? ‘Question No-14: (CAP-II,June-14, 4 Marks) ‘A limited, a widely held company is considering @ major expansion of its production facilities and the following alternatives are available: (Rs in Lakhs) Alternatives ‘Share capital I 50, 20 10 14% Debentures : 20 | Loan from Financial institution @ 16% pa 5 10 | Expected rate of return before tax is @ 25%. Income Tax Rate is 50%. The rate of dividend of the company is not less than 20%, The company at present has no debt. Which of the alternatives you would choose? ‘Question No-15: (CAP-II,June-11, 7 Marks) ‘The capital structure of stable Ltd. is extracted below: (Rs. in mitions) Equity capital: 100 thousand shares of Rs. 100 each 100 Reserve and surplus 120 12% preference shares: 55,000 shares of Rs. 100 each fully pald up 55 114% debentures of Rs. 1,000 each; 3000 numbers 30 Long-term loan from financial institution at 12% per annum 20 325 23‘The Co. Is also availing a bank overdraft of Rs. 2 million carrying interest at 15% p. a. The company is now rawing up its profit plan for the next year. It wants to pay dividend to equity shareholders at 15% and keep the total dividend payout (equity as well as preference shareholders) at 60%. ‘Assuming that the tax rate applicable to the company is 25%, what level of earning (EBIT) should the ‘company try to achieve to meet its plan? Solution: Let“X" be the EBIT to meet the company’s commitments. Particulars Rsin Million Int. on debentures @ 14% on Rs. 3 million a2 Int. on long term loan of Rs. 2 milion @ 12% 028 Tnt. on bank overdraft of Rs. 2 million @ 15% 03 Total Interest 0.96 Profit before tax (PBT) = EBIT - Interest BIT 0.96 =x-096 Tax at 25% (x=0.96)/4 Profit after tax (PAT) =3(«-096)/4 ‘Total dividend payable On preference capital of Rs. 5.5 million @ 12% 066 (On equity capital of Rs. 10 million @ 15% 15 Total Dividend 216 ‘Total dividend payout is limited to 60% of PAT and is also equal to Rs. 2.16. ‘Therefore, [3 (x 0.0.96) /4] x60/ 100 = 2.16 0 3(%-0.96)/4=216/60, x83 Or, x-0.96 = 4.80, Or, x= 4.80 +0.96=5.75 Hence, earnings before interest and tax should be Rs. 5.76 million, Question No-16: Companies X Ltd, Y Ltd and Z Itd are identical in all respects Including risk factors except for debt /equity position in their capital structure, The interest rate of debenture is 10% and the equity capitalization rate of these companies is 12.5%. ‘The position of debenture: 35 follows: Xt Yurd. Zutd Rs 3 Lakhs Re 2 Lakhs Re 1 Lakhs ‘These companies expect annual net operating income (EBIT) of Rs 50,000 1. Calculate the value of these companies and their overall cost of capital under NI approach, 2. overall cost of capital is 12.5%, and debenture interest is 10%, calculate the cost of equity and value of firm under NOI approach, Solution: Value of firm by using Net Income (NI) Approach: Particulars Xitd Yitd Zid ‘Net Operating income (EIT) 50,000 50,000 50,000 Less: Interest 30,000 20,000 10,000 EBT (Net Income) 20,000 30,000 40,000 PyCost of equity (Ke) 12.5% 12.5% 125% ‘Value of Equity (E) = NUKE 160,000 | 240,000 | 320,000 Value of Debt (0) 300,000 | 200,000 ‘| 100,000 Value of Firm (V) =€+D 460,000 | 440,000 | 420,000 Overall Cost (Ko) = EBIT/V 10.87% 11.36% 11.90% Conclusion: ‘As per NI approach, value of firm increases and overall cost decreases if debt component is increased in capital structure. From the above computation, X Ltd. Has more amount of debt, it has lower overall cost and highest market value. Since cost of debt is cheaper, if its proportion is. increased averall cast decreases. Hence Value of firm increases. Value of firm by using Net Operating Income (NOI) Approach: Particulars Xitd Yutd Zid Net Operating income (EIT) 530,000 50,000 50,000 (Overall Cost (Ka) 12.5% 25% 12.5% Value of Firm (V) = EBIT/Ko "400,000 | 400,000 | 400,000 Less: Value of Debt (0) 300,000 | 200,000 | 100,000 Value of Equity (E)= V-D 100,000 | 200,000 | 300,000 EBT (Net income)(As computed above) 20,000 30,000 40,000 Cost of equity (Ke) = N/E 20% 15% 13.33% Conclusion: ‘As per NOI approach, overall cost of capital and value of firm remains constant irrespective of debt component in capital structure. Therefore, Value of all the firms are equal. However, if debt content increases in capital structure, financial risk to equity shareholders increases and hence cost of equity increases due to higher amount of debt. Question No-17: The following is the data regarding two companies X and V belonging to the same equivalent risk class: 0.x co. No. of ordinary Shares 90,000 150,000 Market Price per Share Rs.1.20 Rs 1.00 6% Debentures 60,000 Profit Before interest Rs18,000 Rs 18,000 All profits after debenture interest are distributed as dividends. Explain how under Modigliani & Miller approach, an investor holding 10% of shares in Company 'X’ will be better off in switching his holding to Company " Solution: 1) As per MM approach, investor will shift his holding from high market value firm to low market value firm for arbitrage gain, 2) The market value of X company is 168,000 (80,000 x 1.2 + 60,000) and market value of ¥ company is only 150,000. Hence, investors shift from company X to Y 3) The arbitrage process explained by MM (Levered to unlevered) are: 25Particulars ‘Amount Cash Position: Sale value (9000 x1.2) 10,800 (Obtain personal Loan @ 6% (equal to 10% of 60,000) 6,000 Total available amount 16,800 Invest 1036 of shares in ¥ company (150,000 x 10%) 15,000 Immediate Cash saving 3,800 Income Position: ‘Company | Company BIT 18,000 18,000 Less: Interest 36,00 EBT (Net income) 34,400 118,000 ‘%of shareholding by investor 10% 10% Share of income from company Rs 1440 18,00 Less: interest on personal loan (6000 x 6%) : 360 ‘Net available income for share holder Rs 1440 Rs 1400 Conclusion: From the above computation, the investor if shifts his holding from company X to company Y, his future income form company Y will be equal to the income from company X if he had not shifted. In addition, the investor is able to save immediate cash Cf Rs 1800 if shifting is made. Hence there is a benefit from shifting. Question No-18: Company A and B belong to the same business risk class. Average net operating income before interest of each company is Rs 100 Lakhs. Other related information is given below: Cok 60.8 Market value of equity Rs400 Lakhs Rs 120 Lakhs Market Value of Debentures £85200 Lakhs Total Market Value Rs 400 Lakhs Rs 320 Lakhs Rate of interest on debentures is 15% p.a. and the same is considered to be certain by all the investors. In case the total market values of the two companies are not in equilibrium, explain the process by which equilibrium is restored to according to Modigliani and Miller theory. 4) As per MM approach, investor will shift his holding from high market value firm to low market value firm for arbitrage gain. 5) The market value of A company is 400 lakhs and market value of 8 company is only 320 lakhs. Hence, Investors shift from company A to B 6). The arbitrage process explained by MM (Unlevered to Levered) are: Particulars ‘Amount Cash Position: Sale value (assuring 10% holding in Company A] 40,00,000 Less: Invest 10% of shares in B company (120 Lx 10%) 12,00,000, Less: Invest 10% debentures in B company (200L x 10%) 20,00,000 Immediate Cash saving 8,00,000 Income Position: Company A | Company B EIT 1100,00,000 | 100,00,000 26ess: Interest 7 '30,00,000 EBT (Net Income) 1100,00,000_ | 70,00,000 %ol shareholding by investor 103% 10% ‘Share of income from company Rs 10,00,000 | Rs 7,00,000 ‘Add: Interest income (20L x 15%) - Fs 3,00,000, ‘Net available income for the investor Rs 10,00,000 | Rs 10,00,000 Conclusion: From the above computation, the investor if shifts his holding from company A to company 8, his future income form company B will be equal to the income from company A if he had not shifted. In addition, the investor is able to save immediate cash of Rs 800,000 if shifting is made. Hence there isa benefit from shifting Question No-19: Company X and ¥ are identical in all respects including risk factors except for debt-equity mix. X having issued 10% debentures of Rs 18 lakhs while Y has issued only equity. Both the companies earn 20% before interest and taxes on their total assets of Rs 30 Lakhs. Assuming a tax rate of 40% and capitalization rate of equity is 15%. Compute the value of the companies X and Y using NI approach Solution: Value of firm by using Net Income (Nl) Approach: Particulars Xitd Yutd Net Operating Income (EBIT) 600,000 600,000 Less: Interest 180,000 = EST "420,000 600,000 Less: Tax @40% 1168,000 240,000 EAT(Net income) 252,000 360,000 Cost of equity (Ke) 15% 15% Value of Equity (E) = N/Ke 16,80,000 72400,000, Value of Debt (0) 118,00,000 : Value of Firm (V) 34,80,000 24,00,000 ‘Question No-20: Company X and Y are identical in all respects including risk factors except for debt-equity mix. X having Issued 10% debentures of Rs 18 lakhs while ¥ has issued only equity. Both the companies earn 20% before interest and taxes on their total assets of Rs 30 Lakhs. Assuming a tax rate of 40% and ‘capitalization rate of 15% for an all equity company, Compute the value of the companies X and Y using NOI approach, Solution: Under NOI approach, if there is a corporate taxes, value of levered firm will be higher than the value of Unlevered firm because interest expense is tax deductible and because of this reason, overall cost will be reduced and value of the firm is Increased. As per theory, value of levered firm can be calculated as follows: ‘Step-1: Calculate value of all equity (unlevered firm) ‘Step- 2: Calculate value of levered firm = Value of unlevered firm + amount of debt x tax rate Now, Value of unlevered firm (¥), as calculated in question 19: 24, 00,000 Value of levered firm (X) = 24, 00,000 + 18, 00,000 x 0.4 = 31, 20,000 7Question No-21 (IMP): ‘A.Ltd. i an all equity financed company with a market value of Rs 2500,000 and cost of equity is 219%. The company wants to buy back equity shares worth Rs 500,000 by issuing 15% perpetual debt of the same amount. Tax rate is 30%. After the capital re-structuring and applying MM Model (with taxes), you are required to caleulate- a) Market value of A Ltd. b) Cost of equity and ¢) Weighted average cost of capital Solution: Particulars ‘Amount Value of A Ltd before restructuring (V) 25,00,000 Value of Equity of A Ltd (unlevered or all equity firm) (E) 25,00,000 (Overall cost or Cost af equity (Ke) 21% [Net Income or EAT (NI) = xKe 525,000 EBT= EAT/{i-t [since no debt, EBT = EBIT) 750,000 Value of A Ltd, after restruct Value of unlevered firm 25 00,000 ‘Add: Tax saving on amount of debt (500,000 x 30%) 150,000 Value of A Ltd, after restructuring 650,000 Less: Value of Debt (0) 500,000 Value of Equity (E) 21,50,000 EIT 750,000 Less: Interest (500,000 x 15%) 75,000 est 675,000 Less: Tax @ 30% 202,500 EAT (NI) 472,500 Cost of equity (Ke) = N/E 21.98% Cost of debt after tax (ka) = 15% (1.0.3) 10.5% Ko = Wr of debtx cost of debt + Wt of Equity x cost of equity | 19.81% (5/26.5)x 10.5) + {(21.5/26.5) x21.98] Question No-22: (CAP-II,June-12, 4+4= 8 Marks) Phe! Typewriter Ltd, and Gills Typewriter Ltd. are identical in all respect except for capital structure, Phel has 50 percent debt and 50 percent equity financing whereas Gillis has 20 percent debt and 80 percent equity financing, in market value terms. ‘The borrowing rate for both companies is 13 percent in ano-tax world and capital markets are assumed to be perfect. The earnings of both companies are not expected to grow, and all earnings are paid out to shareholders in the form of dividends. Required: (i) Ifyou own 2 percent of common stock of Phel, what would be your rupee return if the company has ret operating income of Rs. 360,000 and the overall capitalization rate of the company is 18 percent? What is the implied equity capitalization rate? (i) Gills has same net operating income and overall capitalization rate as Phel. What is the implied equity capitalization rate for Gillis? Why does it differ from Phel? 28Solution: Particulars Phel Typewriter Ltd. | Gillis Typewriter Ltd, EIT 360,000 '360,000 Overall cost (Ko) 18% 18% Value of firm (V) 20,00,000 220,00,000 Less Value of Debt (D) (50% and 20%) 110,00,000 00,000, Value of Equity (E) 110,00,000 116,00,000 EsiT 360,000 '360,000 Less: Interest @ 13% 130,000 52,000 ‘Net Income (EBIT = interest) 230,000 308,000 Cost of Equity (Ke) = NE 23% 19.25% Share of investor on Phel @ 2% of 230,000 Rs 4,600 : Equity capitalization rate for Gills differ from Phel. Since Phel has more amount of debt, tis, ‘more risky to the equity shareholders. Hence, cost of equity of Phel is more than the cost of equity of Gils ‘Question No-23: CAPII, Dec-13, 5+3=8 Marks) ‘A.company requires Rs. 1,500,000 for the installation of a new unit, which would yield an annual EBIT of Rs, 250,000. The company’s objective Is to maximize EPS. It is considering the possibilty of raising a debt of either Rs. 300,000 or Rs. 600,000 or Rs. $00,000 plus issuing equity shares. ‘The current market price per share is Rs. 5O which is expected to drop to Rs. 40 per share, if the market borrowings were to exceed Rs. 700,000. The cost of borrowings is indicated as follows: Level of borrowings Cost of borrowings Up to Rs. 200,000 D%pa More than Rs. 200,000 to Rs. 600,000 1s%pa More than Rs. 600,000 to Rs. 900,000 7% pa Required: ‘Assuming a tax rate of 50%, work out the EPS and the scheme, which you would recommend to the company. Calculate return on capital employed under each scheme and explain the leverage effect. Question No-24: (CAP-II,June-16, 7 Marks) ‘A.company requires Rs. 25, 00,000 for a new plant. Ths plant is expected to yield earnings before interest and taxes of Rs. 5, 00,000. While deciding about the financial plan, the company considers the objective ‘of maximizing earning per share. Ithas three alternatives to finance the project as below: 1). Raise debt of Rs. 2,50,000 and balance by issuing equity shares, 2). Raise debt of Rs. 10,00,000 and balance by issuing equity shares 3) Raise debt of Rs. 15,00,000 and balance by issuing equity shares ‘The company's share is currently selling at Rs. 150, but is expected to decline to Rs. 125 in case the funds are borrowed in excess of Rs. 10, 00,000. Assume that company can raise cash from issue of equity at these market prices. ‘The funds can be borrowed at the rate of 10% up to Rs. 2,50,000, at 15% over Rs. 2,50,000 and up to Rs, 110,00,000 and at 20% over Rs. 10,00,000. The tax arte applicable to the company is 50%. Required: Which form of financing should the company choose? 29