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    Soft Drink Company

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    manish_mittal
    This is a famous case on Financial management under the heading capital budgeting. I have provided the solution here.

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    Soft Drink Company

    Uploaded by

    manish_mittal
    217 views6 pages
    This is a famous case on Financial management under the heading capital budgeting. I have provided the solution here.

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    This is a famous case on Financial management under the heading capital budgeting. I have provided the solution here.

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    217 views6 pages

    Soft Drink Company

    Uploaded by

    manish_mittal
    This is a famous case on Financial management under the heading capital budgeting. I have provided the solution here.

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    You are on page 1of 6

    2009

    Case Analysis:
    SoftDrink Company
    Capital Structure Decision

    Submitted By

    Sec A (Seat No. 61-66)


    Manish Mittal 09BSHYD0427
    Kirti 09BSHYD0384
    Neha Gupta 09BSHYD0498
    Ritika Choraria 09BSHYD0671
    Surbhi Nagpal 09BSHYD0890

    Submitted To

    Dr. Vunyale Narender

    IBS
    Hyderabad
    12/7/2009
    Case analysis
    The case analysis has been done in following steps:
     Calculation of expected sales using the projected sales figures and associated
    probabilities
    SALES PROBABILITY EXPECTED SALES
    400000 0.25 100000
    600000 0.5 300000
    800000 0.25 200000
    TOTAL 600000
    Table 1.1
     Calculation of EBIT

    EXPECTED SALES 600000


    LESS VARIABLE
    300000
    COST@50%
    CONTRIBUTION 300000
    LESS FIXED COST 200000
    EBIT 100000
    Table 1.2
     Calculation of proportion of debt in the capital structure as per various
    options available with the Company
    TOTAL CAPITAL=RS 500000
    DEBT% DEBT AMOUNT COST OF DEBT
    0 0 0.000
    10 50000 0.090
    20 100000 0.095
    30 150000 0.100
    40 200000 0.110
    50 250000 0.135
    60 300000 0.165
    Table 1.3
     Evaluation of various options available to the company
    PARTICULARS 1 2 3 4 5 6 7
    PROPORTION OF DEBT 0% 10% 20% 30% 40% 50% 60%
    AMOUNT OF DEBT 0 50000 100000 150000 200000 250000 300000

    EBIT 100000 100000 100000 100000 100000 100000 100000

    LESS INTEREST 0 4500 9500 15000 22000 33750 49500

    EBT 100000 95500 90500 85000 78000 66250 50500

    NO OF EQUITY SHARES 25000 22500 20000 17500 15000 12500 10000

    DPS 4.00 4.24 4.53 4.86 5.20 5.30 5.05

    COST OF EQUITY(Ke) 0.20 0.21 0.23 0.24 0.26 0.27 0.25

    COST OF DEBT(Kd) 0.000 0.090 0.095 0.100 0.110 0.135 0.165

    VALUE OF EQUITY(E) 500000 450000 400000 350000 300000 250000 200000


    VALUE OF DEBT(D) 0 50000 100000 150000 200000 250000 300000
    VALUE OF FIRM(V) 500000 500000 500000 500000 500000 500000 500000
    Ko(WACC) 0.2000 0.2000 0.2000 0.2000 0.2000 0.2000 0.2000
    Table 1.4
    Working Notes

    GIVEN THAT
    SHARE VALUE P0= 20
    NOW,
    P0=DIV/ke
    THUS Ke=DIV/P0
    Where P0=
    Price in period
    zero
    DPS= (EBIT-INT)/No. of Shares
    Also,
    Ko (WACC) =[ Ke * {E/(E+D)}] + [ Kd * {D/(E+D)}]
    The dividend payout ratio is 100% ,therefore, EPS=DPS

    Value of equity is the capitalized value of net earnings i.e. net income
    Value of Equity(E) = (EBIT- Interest)/Ke
    Value of Debt(D) = (Interest)/Kd
    Value of Firm(V) = E+D

    Findings
    As we can see from the Table1.4 that the value of the firm and the WACC for
    the company remains the same under various Capital Structure options
    available to the Company.
    Thus we can infer that the value of the Firm is not affected by the capital
    structure decision.

    0.30

    0.25

    0.20
    Ke
    Kd ,Ke,Ko 0.15
    Kd
    0.10 Ko

    0.05

    0.00
    1 2 3 4 5 6 7
    Options
    From the graph we can see that Ko is constant and Ke is increasing at a decreasing
    rate and eventually falling after extremely leveraged situation i.e. after Option 6.
    The cost of debt is constantly increasing because the risk perception of the debt
    holders increases with increased leverage.

    Relevance : Modigliani and Miller (MM) Hypothesis Proposition II


    The MM model provides the behavioral justification of the Net Operating Income
    approach (NOI Approach) and explains the irrelevance of capital budgeting
    decision on the value of the firm as is evident from table 1.4 above.
    According to Proposition II the levered firm’s opportunity cost of capital will not
    rise even if very excessive use of financial leverage is made. The excessive use of
    debt increases the risk of default. Hence, in practice, the cost of debt, Kd, will
    increase with high level of financial leverage. MM argued that when Kd increases,
    Ke will increase at a decreasing rate and may even turn down eventually. The
    reason for this behavior of Ke , is that debt holders, in the extreme leveraged
    situation own the firm’s assets and bear some of the firm’s business risk. Since the
    operating risk of shareholders is transferred to debt holders, Ke declines.
    Now, our situation is matching with that of MM because our cost of debt is
    increasing with financial leverage and Ke is also increasing but at a decreasing rate
    and eventually turns down after Option No.6 because of extremely leveraged
    situation (60% Debt Employment).
    Answers:
    Q1 As a finance manager, using the data, decide upon a choice of the capital
    structure that you would advise the firm.
    Ans. The capital structure of equal proportion of debt and equity is advisable to the
    firm.
    Q2. The reasons for the usage of specific proportion of debt i.e. Leverage
    Ans. The dividend per share (DPS) is increasing with increased leverage i.e.
    increased use of debt, up to Option 6 i.e. 50% debt in the capital structure (from
    Rs.4.00 per share to Rs. 5.30 per share) but after this point the DPS falls from
    Rs.5.30 to Rs.5.05.If the goal of the management is to maximize the return to the
    shareholders option 6 is optimum capital structure.
    Q3. What can be best option for the firm?
    Ans. The Option no. 6 having 50% debt in the capital structure should be used by
    the firm.
    Q4. Why your option is the best bet- reasons to substantiate the same?
    Ans. According to Pecking Order Theory, in a capital structure decision the firm
    usually follows the following order in raising the capital
    1. Managers always prefer to use internal finance (Retained Earnings).
    2. When they do not have internal finance, they prefer issuing debt. They first
    issue secured debt and then unsecured debt followed by hybrid securities
    such as convertible debentures.
    3. As a last resort, managers issue shares to raise finances.
    Since it is assumed that there are no retained earnings, the firm goes for debt
    financing and keeps on increasing the proportion of debt, but up to a certain extent.
    In our case when we increase the debt proportion to 60% the return to shareholders
    i.e. Dividends decreases from Rs.5.30 to Rs.5.05
    Moreover DPS is continuously increasing with increasing financial leverage.
    Thus Option 6 with 50% debt is the best bet.

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