No.1 for CAICWA & MEGICEC MASTER MINDS 4. CAPITAL STRUCTURE Given information Additional amount required = 50,000 Tax rate = 50% PART - A (EBIT remains same) Evaluation of financial plans basing on EPS Particulars present | 100% equity | 100% preference | 100% debt a EBIT 40,000 40,000 40,000 40,000 b. interest - - - (6,000) cc. EBT 40,000 40,000 40,000 [35,000 dd. Tax@50% (20,000) (20,000) (20,000) [17,500 e. EAT / EASH 20,000 20,000 20,000 17,500 f. Pref shares 5 5 5 - (9. EAESH 20,000 20,000 74,000 77,500 h. No of Equity shares 10,000 15,000 10,000 [10,000 i EPS (g/h) 2 1.33 14 [1.75 {Impact on EPS : “0.67 -0.60 -0.25 If there is no change in EBIT, it is not advisable to go for expansion. This is because as a result of expansion the companies EPS is decreased in all option PART-B(EBIT inereegSy 10,000) Particulars present | 100%, 100% preference | 100% debt a EBIT 40,000 | 50,990 50,000 50,000 b. interest = 7 = (6,000) EBT 40,000 0 50,000 45,000 d. Tax@50% (20,000). $435,000), (25,000) (22,500) e. EAT / EASH 20, 000.WF25,000 25,000 22,500 Pref shares = = 6,000 = (9. EAESH 20,000 | 25,000 19,000 22,500 h. No of Equity shares 10,000 | 15,000 10,000 10,000 iL EPS 2 1.67 1.9 2.25 j. Impact on EPS = -0.33 -0.1 0.25 Conclusior 1) after expansion the companyRs.s EBIT increase by Rs. 10,000 than itis better to choose option-I 2) as it increase the EPS the company by 0.25. therefore it is better to choose additional capacity by issue of 10% debentures PROBLEM NO: 2 Particulars Plan A Plan B Plane Plan D EeiT 1500000 4800000 4500000 1500000 Less: Interest 0 (180000) (00000) 0 EBT 7500000 41320000 1200000 7500000 Lass: Tax@50% (750000) (660000) (600000) (750000) EAT 750000 660000 600000 750000 Less: Preference Dividend 0 0 0 150000 EAESH 750000 660000 600000 ‘600000 No. of Equity shares 80000 60000 ‘50000 60000 EPS 9.375)- 11 12 101 Conclusion: From above computation we can decide that Plan ‘C’ i.e Rs.12 EPS is highest. So it is advised to company to Opt. ‘Plan C’ CA Inter_39e_F.M_Capital Structure_Assignment Solutions 44885125025/26 www.mastermind: PROBLEM NO: 3 Working Note ~ 1 (Calculation of Interest) Particulars Option-1 (50%) Option-Ii (60%) Option-Iil (40%) ‘a. upto 40L [(40Lx15%) = 6L. [(40Lx15%) = 6L. [(40Lx15%) = 6L. b. 40L-BOL (10Lx16%) = 1.6L (40Lx16%) = 1.6L = c. above 50L = (10Lx18%) = 1.8% = Total 7.6L 9.4L a Evaluation of financial plans (basing on EPS) ‘Amt in 00,000 Particulars Option-l Option-Ir Option-Iil a EBIT 22 22 22 b, Interest (7.6) (8.4) © c. EBT (a-b) 14.4 12.6 16 d Tax @ 50% 72) (63) ® e. EAT/ EAESH (-d)_| 7.2 63 8 £. No. of equity shares | 50/40 = 1.25 60/40= 15 40/32 = 1.25 g. EPS (eff) 5.76 42 64 Note: company issue shares only at market price, because issue less no.of shares and increases sale proceeds but dividend can be paid only on face value of a share Conclusion: option-| is better because EPS more than other two options. As EPS maximize under option-| it is advisable to raise required capital in the proportiopyof Rs.50 lacks equity and Rs.50 lacks debt PROBLEM Ni The EPS is determined as follows: >Siternatives: Particulars j W MI (Rs.1,00,000 deby CS) _(Rs.4,00,000 debt) (Rs.6,00,000 debt) EBIT 1,60) 7,60,000 7,60,000 Interest 80 44,000 74,000 PBT 752,000 7,16,000 ‘86,000 Taxes at 50% 76,000 58,000 43,000 PAT 76,000 58,000 43,000 No.of shares 36,000 24,000 20,000 EPS 241 2.42 2.15 The second alternative maximizes EPS; therefore, it is the best financial alternative in the present case. The interest charges for Altemative Il and Ill are calculated as follows: Interest calculation, Alternative Il Particulars ‘Amount. 1,00,000@8% 8,000 3,00,000@12% 36,000 Total 44,000, Interest calculation, Alternative Ill Particulars ‘Amount 1,00,000@8% 8,000 4,00,000@ 12% 48,000 1,00,000@ 18% 48,000 Total 74,000 The number of shares is found out by dividing the amount to be raised through equity issue by the market price per share. The market price per share is Rs.25 in case of first two alternatives and Rs.20 in case of last alternative. CA Inter_39e_F.M_Capital Structure_Assignment Solutions 4.2No.4 for CAICWA & MECICEC MASTER MINDS PROBLEM NO: 5 Firm Expected EPS PIE multiple Value of share A Rs. 5.00 83 a5 B 7.50 125 93.75 c 3.00 152 45,60 D 4.00 115 46 E 8.50 22.0 187 PROBLEM NO: 6 Particulars ‘Option -1 Option - EBIT (87,000 + 1,50,000 x 10%) 46,000 46,000 4 t Old EBIT Additional Shares Less: Interest (W.N 1) (4500) (7000) EST 41500 45000 Less Tax@35% (14525) (15750) EAT/EAESHS, 26975 29250 No. of Eq, shares (W.N 2) 5000 7000 EPS 5.395 4.478 P/E Ratio 6 7 Market price 32.37 29.25 WORKING NOTES 1: Calculation of interest on Debt S Option 1: SS 5% Debentures of Rs.20,000 i.e. 5% x Rs.20, 7% Debt of Rs.50,000 i.e. 7% x Rs. seg Option 2: 5% Debentures of Rs.20,0089 WORKING NOTES 2: Calculation of number of equity shares to be issued: Option 4 Existing sone = 5000 shares Option 2: Existing $0,000 = 5000 shares ‘Copyrights Reserved D To MASTER MINDS, Guntur Newissue = —22992_ = 9000 shares 25(MPS) 7,000 shares jon ;- Since M.P under option — | is more than option ~ I, itis advisable to accept Option —| PROBLEM NI Calculation of EPS & Market price in each of the given options (Rs. In Lakhs) Particulars Existing ‘Option Option I EBIT WANA) 72.00 15 15 (100x12%) | (125%12%) | (125.x12%) (125 x 12%) Less: Interest 1.78 1.75 1.78 375 (257%) (1.75425 x8%) CA Inter_39e_F.M_Capital Structure_Assignment Solutions. 43885125025/26 www.mastermind: EBT 10.25 13.25 13.25 11,25 Less: Tax @ 50% 5.125 6.625 6.625 5.625 EAT 5.125 6.625 6.625 5.625 Less: Preference dividend 225 225 475 2.25 (25x9%) (2.25 +25 x 10%) EAESH @) 2.875 4375 1.875 3.375 No. of equity shares (Lakhs] Existing 0.40 0.40 0.40 0.40 New - 0.20 - - ‘Number of Equity shares @) 0.40 0.60 0.40 0.40 EPS (Rs.) (A/B) 719 7.29 4.69 8.44 PE ratio 5 20 17 16 Market price (EPS X PE ratio) : 146 80 135 W.N-1: Calculation of EBIT EBIT = 12% of capital employed Capital employed (Before expansion): Equity share capital Rs.40,00,000 Debt Rs.25,00,000 Preference share capital —_Rs.25,00,000 Reserves and surplus Rs.10,00,000 Rs.1,00,00,000 Capital employed (After expansion) = 1,00,00,000 + Additional 1,25,00,000 EBIT, before expansion 1,00,00,000 x 12% EBIT, after expansion Conclusion: RS by way of fresh equity shares Ww Assumption: The return on existing capitaPis given as 12%. It is assumed that the same rate of Tetum will be maintained on additional investment also. Let ‘x’ b the EBIT at Indifference point W.K.T at Indifference point EPS, = EPS, (x-Int)(1-Tax)-PD _ (x-Int)(—Tax) -PD No of Eqshares NoofEqshares (x=0)(1-0.35)—0 _ (x-15L)(1-0.35)-0 ‘300000 200000 By Solving the Equation x= 45 lakhs EBIT at |.D.P = 45 Lakhs Conclusion: If EBIT is 45 lakhs then EPS will be same under both the options i.e., Rs. 9.75 per share. Copyrights Reserved To MASTER MINDS, Guntur CA Inter_39e_F.M_Capital Structure_Assignment Solutions 44No.1 for CAICWA & MECICEC MASTER MINDS ‘Assumed equity share F.V = Rs.100 Let ‘x’ be the EBIT at .D.P WKT AtLD.P EPS, = EPS. Serta Tax)=PD _ (x= Inl)Q— Tax) PD Interest *=60L x2x18% = 40Lx18%-7.2L No of shares Noof shares 3 (x=0)(1-0.4)-0 _ (x=7.2L)(1-0.40)-0 60,000 20,000 x(0.8) (0.6) Bonen ~*~ 720000555 X= 3x 21,60,000 2x = 21,60,000 X= Rs.10,80,000 EBIT at |.D.P = Rs.10,80,000 60,000 shares e (ji) is accepted, then the EPS of the firm would be EPS Alternative (i) = (EBIT=0:12xRs 400,000) (1-0.96) (0.14 xs 2,00,000) 40,000 shares. In case the alterns In order to determine the indifference level of EBIT, the EPS under the two altemative plans should be equated as follows (EBIT- 0.12 xRs 4,00,000) (1-0.35) _ (EBIT -0.12 x Rs 4,00,000) (1-0.35) - (0.14 x Rs 2,00,000) 60,000 shares 40,000 shares , OSSEBIT- Rs31,200 = O.6SEBIT- Rs 59,200 3 2 oO Or 1.30 EBIT — Rs 62,400 Or (1.95 - 1.30) EBIT 1.95 EBIT — Rs 1,77,600 Rs 1,77,600 - Rs 62,400 = Rs 1,15,200 Rs1,15,200 oresiT = R81,16,200 / 0.65 oresiT = RS 1,77,231 CA Inter_39e_F.M_Capital Structure_Assignment Solutions 45885125025/26 www.mastermind: PROBLEM NO: 11 Let ‘x’ be the level of EBIT at |.D.P WT at LD.P EPS; = EPS, (x= 2L(w.n))(1-0.5)-0 _ (x-260000(w.n))(1-0.5) -0 Copyrights Reserved ee oe ‘To MASTER MINDS, Guntur By Simplify X= 1160000 EBIT at |.D.P = 1160000 WORKING NOTE: Interest on Plan I = 20,00,000 x 10% = 2,00,000 Interest on Plan Il = 20,00,000 x 10%+5,00,000 x 12% = 2,60,000 PROBLEM NO: 12 (i) Amount = Rs 80,00,000 Plan | Equity of R's 60,00,000 + Debt of Rs 20,00,000 Plan il = Equity of Rs 40,00,000 + 12% Debentures of Rs 40,00,000 Plan I: Interest Payable on Loan = 12% x Rs 20,00,000 = Rs 2,40,000 SS Plan II: Interest Payable on Debentures gs = 12% x Rs 40,00,000 = Rs 4,80,000 Computation of Point of Indifference EBIT-1))(1-t) = Ey E. (EBIT - Rs2,40,000) (1-0.3) _ (EBIT-Rs4,80,000) (I-0.3) 60,000 40,000 2 (EBIT —Rs 2,40,000) = 3 (EBIT - Rs 4,80,000) 2EBIT—Rs 4,80,000 = 3 EBIT-Rs 14,40,000 2 EBIT -3 BIT = - Rs 14,40,000 + Rs 4,80,000 EBIT = Rs 9,60,000 (ii) Earnings per share (EPS) under Two Situations for both the Plans Situation A (EBIT is assumed to be Rs 9,50,000) Particulars Plant Plan il EBIT 9,50,000 9,50,000 Less: Interest @ 12% (2,40,000) (4,80,000) EBT 7,10,000 4,70,000 Less: Taxes @ 30% (2.13,000) (4.41,000) EAT 4,97,000 '3,29,000 No. of Equity Shares 60,000 40,000 EPS 8.28 8.23 Comment: In Situation A, when expected EBIT is less than the EBIT at indifference point then, Plan | is more viable as it has higher EPS. The advantage of EPS would be available from the use of equity capital and not debt capital CA Inter_39e_F.M_Capital Structure_Assignment Solutions 46No.1 for CAICWA & MECICEC MASTER MINDS Situation B (EBIT is assumed to be Rs 9,70,000) Particulars Plant Plan i EBIT 970,000 '9,70,000 Less: Interest @ 12% (2,40,000) (4,80,000) EBT 7,30,000 4,90,000 Less: Taxes @ 30% (2,19,000) (1,47,000) EAT 5,11,000 '3,43,000 No. of Equity Shares 60,000 40,000 EPS 852 8.58 ‘Comment: In Situation B, when expected EBIT is more than the EBIT at indifference point then, Plan II is more viable as it has higher EPS. The use of fixed-cost source of funds would be beneficial from the EPS viewpoint. In this case, financial leverage would be favourable. (Note: The problem can also be worked out assuming any other figure of EBIT which is more than 9,60,000 and any other figure less than 9,60,000. Alternatively, the answer may also be based on the factors/governing the capital structure like the cost, risk, control, etc. Principles) ROBLEM NO: 13 Particulars Proposal P Proposal Q Proposal R EBIT 1800000) 1800000 1800000 Less: Interest @ 10% 0 200000 0 EBT 180004 17600000 41800000 Less: Tax @ 50% 9 800000 900000 EAT NH 800000 900000 Less : Pref. Div Lao 0 200000 EAESHS & 900000) 800000 700000 No of Eq Shares 200000) 4100000 100000 Eps 45) 8l- 7H EBIT for F.B.E.P 400000 aa) ° 200000 200,000) tax “os a) |.D.P between plan P & plan Q (*-0)(1-0.5)-0 _ (x-21)(1-0.5)-0 200000 700000 2 [(-2L)0.5] = 0.5 x 2 [0.6x-1L=0.5x 1.0x-2L=0.5x 05x=2L X = 400000 b) LDP between plan Q & plan R (x-2L(1=-0.5)-0 _ (x-2L)(1-0.5)-0 00000 100000 There is no indifference point between plan Q & R ¢) |.D.P between plan P & plan R (x=0)(1=0.5)—0 _ (x-0)(1-0.5)-2 200000 100000 CA Inter_39e_F.M_Capital Structure_Assignment Solutions, 47885125025/26 www.mastermind: 0.5x__ 0.5x~200,000 200000 100000 2,00,000 _ = Rs.8,00,000 Analysis: It can be seen that financial plan Q dominates Plan R, since the financial BEP of former is ‘only Rs.2,00,000 but in case of latter it is Rs.4,00,000 PROBLEM NO: 14 (a) ‘Alternatives Panis Tate aedtona [Aten twe | tera ue (Rs) (Rs) (Rs) EBIT 15,00,000 15,00,000 [15,00,000 Interest on Debts: - on existing debt @10% (3,60,000) (3,60,000) (3,60,000) = on new debt @ 12% (4,80,000) = [= Profit before taxes 6,60,000 14,40,000 14,40,000 Taxes @ 40% (2,864,000) (4,56,000) (4,568,000) Profit after taxes 3,96,000 6,84, 9985) (6,84,000 Preference shares dividend _|-- (4 SSS} = Earnings available to equity |3,96,000 ZRH 6,84,000 Shareholders Number of shares 8,00,000 700,000 10,50,000 Earnings per share 0.495 0.305 0.651 a: EARNINGS FER SHURE (b) Approximate indifference points: Debt and equity shares, Rs 24 lakhs, preference and equity shares, Rs 33 lakhs in EBIT; Debt dominates preferred by the same margin throughout, there is no difference point. Mathematically, the indifference point between debt and equity shares is (in thousands): EBIT*-Rs840_EBIT*-Rs 360 ‘800 1,050 EBIT* (1,050) ~ Rs.840(1,050) = EBIT* (800) — Rs.360 (800) 250EBIT* = Rs.5,94,000 EBIT* = Rs.2,376 CA Inter_39e_F.M_Capital Structure_Assignment Solutions 48No.1 for CAICWA & MECICEC MASTER MINDS Note that for the debt alternative, the total before-tax interest is Rs.840, and this is the intercept ‘on the horizontal axis. For the preferred stock alternative, we divide Rs.440 by (1-0.40) to get Rs733, When this is added to Rs360 in interest on existing debt, the intercept becomes Rs. 1,093 (c) For the present EBIT level, equity shares is clearly preferable. EBIT would need to increase by Rs.2,876 ~ Rs. 1,500 = Rs.876 before an indifference point with debt is reached. One would want to be comfortably above this indifference point before a strong case for debt should be made. The lower the probability that actual EBIT will fall below the PROBLEM NO: 15 Computation of Expected EPS for the Expected Earnings Before Inlerest and Tax forthe Expected EBIT Debt Equity Rs. Rs. Expected eamings before Inlerest and tax 15,000| 18,000) Less: Interest (12% of Rs.50,000) 8,000 Earnings Before Tax 9,000 15,000) Less: Tax @ 46% of EBT (5.9000 x 46%) 4,140 6,900} Eamings Available to Equity Holders A) 4,260 8.100 Number of Shares Issued: (B) (W.N.) 10,000 12,500] Eamings Per Share 0.486 0.648 Conclusion: EPS is higher when the company raises additional funds by issue of Equity Shares. Working Note: Number of Shares to be issued’ Amount Required: ang 000 Market Price Per Share: 's.20/- No of New Shares to be issued (i)(i) SS ooo (ii) Computation of Indifference Lev IT for the two alternatives (ert -Rs.6,000)(1-0.46) _ eait( NWS) 10,000 Shares 12,500 Shares EBIT = Rs.30,000 There fore, the Indifference Level of EBIT for two alternatives is Rs, 30,000/- (iii) The EPS for the EBIT at the Indifference Level. __Rs.30,000(1-0.46) 12,500 Shares EPS = Rs.1.296/- per share. EPs PROBLEM NO: 16 Given information, Capital investment = 4.50 cr. Rate of interest = 12% Corporate tax = 50% Company has 2 options: Option-1 To arrange the entire amount by issuing equity shares Option-II_: To arrange the amount by means of debt & equity in the ratio of 2:1 i.e. 3 Cr. of Debt & 4.5 Cr. of equity, CA Inter_39e_F.M_Capital Structure_Assignment Solutions 49885125025/26 www.mastermind: Estimation of Indifference Point: Let, X represents the level of EBIT at which EPS is same under both the options. = (EBIT-Int) (1-tax)-prefidiv _ (EBIT-int) (1-tax)-pretdiv No.of equity shares No.of equity shares = 0 Int) (tte) cit) (1- tax) No.of equity shares No.of equity shares = (%-0)(1-0.5) _(x- 36lakhs) (1-0.5) 45lakhs ‘15lakhs =, 05x __0.5x-18lakhs @Slakhs ——‘15lakhs > 0.5 x = 1.5 x— 54 lakhs = 1x= 54 lakhs, = x= 54 lakhs = EBIT = 54 lakhs If EBIT is Rs.54 lakhs then EPS will be same under both options. i.e., 0.6 per share. Assumption: Face value of equity shares is assumed Rs. 10 per share. PROBLEM Ni a {i) Calculation of total value of the firm SS (Rs) a) EBIT 1,00,000 b) Less: Interest (@10% on Rs 5,00, 50,000 c) Earnings available for equity hold 50,000 d) Equity capitalization rate i.e. Ke 15% Earnings available for equity holders k, Value of equity holders = 50,000 / 0.15 = Rs 3,33,333 Value of Debt (given) D 5,00,000 Total value of the firm V = D + S (5,00,000 + 3,33,333) 8,33,333 {ii) Overall cost of capital = Ke = K, (S/V) + Ky (DIV) or EBIT / V 0.15 (3,33,333 / 8,33,333) + 0.10 (5,00,000/ 833,333) 1 [50,000 + 50,000] = 12.00% 833.588 PROBLEM NO: 18 i) Market value of Debt (25000 x 150) = 37,50,000 ii) Market value of equity = EAESH _ 20.00,000-5.25.000 - 99 4 750 ke 16% iil) Market value of Firm [M.v of debt + M.v of equity] = 1 ,29,68,750 (92,18,750 + 37,50,000) iv) Overall coc (K.) = —EB!T__= 2000000 _45 goo, MVotFim 12968750 CA Inter_39e_F.M_Capital Structure_Assignment Solutions 4.10No.1 for CAICWA & MECICEC. MASTER MINDS PROBLEM NO: 19 Value of a firm (V) = EBIT / Overall cost of capital(K.) or, Rs 9,00,000 / 0.12 = Rs 75,00,000 Market value of equity (S) = Value of the firm (V) — Value of Debts (D) = R875,00,000 — Rs30,00,000 = Rs 45,00,000 Calculation of Cost of Equity Overall Cost of Capital (Ko) = Ke(S/V) + K.(D/V) (KoxV)- (KaxD) s Or, = (0.12xRS75,00,000) -(0.10xRs30,00,000) _ Rs9,00,000 -Rs3,00,000 Rs45,00,000 Rs45,00,000 Or, Kox V = (Kex S) + (Ka D) Or, Ke= = 0.1333 of 13.33% Evaluation of different capital structures given in the problem: % of debt | % of equity | Cost of debt(K) [Cost of equity(K) WACE (Ko) 0% 100% 6% 11.5% 11.5% 10% 90% 6% 12% 610% 12°90%= 11 4% 20% 80% 6% 12% (6720%+12°80%=10.8% 30% 70% 6.5% 13% 6.5*30%t13°70%=11.05% 40% 60% 7% co 7*40%+15°60%=11.8% ‘50% 50%. 75% OS % 12.25% 60% 40% 8% 20% 12.8% Decision: since the WACC is minimum 20 bt and 80% equity represents optimum capital structure LEM NO: 21 Calculation of M.V of Firm & K. Particulars Existing Prop! Prop Il MLV of Debt o 600000 1000000 MV of 1875000 1411764 ‘900000 Equity 3L 3L-0.6L 3L-1.2L] 16% 17% 20% | i) MV of Firm 1875000 2011764 1900000 (+i) iv) Over all coc. 16% 14.91% 15.78% K,) 5 (Ke) [:22 00n-0] [ SL fo), 411704 (9 [222% 20m 8.75. 2011764 2011764 To | PROBLEM NO: 22 {i) Calculation of Value of Firms ‘A Ltd.’ and ‘B Ltd’ according to MM Hypothesis Market Value of ‘A Ltd’ (Unievered) = EBIT(I-t) _Rs2,50,000(1-0.30) _Rs175,000 Vu =Rs8,75,000 Ke 20% 20% Market Value of 'B Ltd.’ (Levered) Vo = Vu+ TB CA Inter_39e_F.M_Capital Structure_Assignment Solutions 4.111885125025/26 www.mastermind ' 8,75,000 + (RS10,00,000 x 0.80) = Rs 8,75,000 + Rs 3,00,000 = Rs 11,75,000 (ii) Computation of Weighted Average Cost of Capital (WACC) WACC of A Lil” = 20% (i.e. Ke= Ke) WACC of ‘B Ltd.’ BLtd. (RS) EBIT 250,000 Interest to Debt holders (1,20,000) EBT 130,000 Taxes @ 30% (39,000) income available to Equity Shareholders 97,000 Total Value of Firm 11,75,000 “Less: Market Value of Debt (10,00,000) Market Value of Equity 1,75,000 Return on equity (Ke) = 97,0007 1,75,000 0.52 Computation of WACC B. Ltd ‘Component of | Amount Weight Cost of Capital | WAC Capital | | Equity 4,75,000 0.149 052 0.0775 Debt 10,00,000 0.851 9,084" 0.0715 Total 11,75,000 0.1490 *Ks= 12% (1- 0.3) = 12% * 0.7 = 8.4% SY WACC = 14.90% PRO! 3 Firms Particulars Si a NOVESIT 520,000 R5.20,000 Debt Rs.1,00,000 Ke 10% 71.50% Kd = Ti Nol interest Value of equity (S) = NOL mers 20000 =Rs.2,00,000, s,, = 20000-7000 Rg 1,413,043 11.50% Vi= Rs.2,00,000 Vn= 1,138,043 + 1,00,000 {V = S + D} = Rs.2,13,043 ‘Assume you have 10% share of levered company. i.e. M. Therefore, investment in 10% of equity of levered company = 10% x 1,13,043 = Rs.11,304.3 Return will be 10% of (20,000 — 7,000) = Rs.1,300, Alternate Strategy will be: Sell your 10% share of levered firm for Rs. 11,304.3 and borrow 10% of levered firms debt i.e.10% of Rs. 1,00,000 and invest the money i.e. 10% in unlevered firms stock Total resources /Money we have = 11,304.3 + 10,000 = 21,304.3 and you invest 10% of2,00,000 = Rs. 20,000 ‘Surplus cash available with you is = 21,304.3 — 20,000 = Rs. 1,304.3 CA Inter_39e_F.M_Capital Structure_Assignment Solutions 4.12No.1 for CAICWA & MECICEC MASTER MINDS Your return = 10% EBIT of unlevered firm — Interest to be paid on borrowed funds i.e, = 10% of Rs. 20,000 ~ 7% of Rs. 10,000 = 2,000 - 700 = Rs. 1,300 i.e. your return is same i.e. Rs. 1,300 which you are getting from ‘N’ company before investing in ‘M’ company. But still you have Rs. 1,304.3 excess money available with you. Hence, you are better off by doing arbitrage. PROBLEM NO: 24 Firms Particulars v c NOVESIT RS. 20,000 Rs. 20,000, Debt = Rs. 7,00,000 Ke 10% 18% Ka 7% Value of equity capital (s) = = 20000 000 — Rs. 2,00,000 = Rs. 72,222 Total value of the firm v=S+D Rs. 2,00,000 +Rs. 72,222 + 1,00,000 = Rs. 1,72,222 Assume you have 10% shares of unlevered firm i.e. investment of 10% of Rs. 2,00,000 = Rs. 20,000 and Return @ 10% on Rs. 20,000. Investment will be 10' 20,000 = Rs. 2,000. Alternative strategy: debt i.e. 10% equity of levered firm 222 10% debt of levered firm 000 Total investment = 17,222 Your resources are Rs. 20,000 earnings available for equity i.e. 10% « Sell your shares in unlevered firm for Rs. cao fy 10% shares of levered firm's equity plus ‘Surplus cash available = Surplus — Investment = 20,000 - 17,222 = Rs. 2,778 Your return on investment is: 7% on debt of Rs. 10,000 700 10% on equity ie, 10% of earnings available for equity holders i.e. (10% « 13,000) 1,300 Total return 2,000 i.e. in both the cases the return received is Rs. 2,000 and still you have excess cash of Rs. 2,778. Hence, you are better off i.e you will start selling unlevered company shares and buy levered company’s shares thereby pushing down the value of shares of unlevered firm and increasing the value of levered firm till equilibrium is reached. ‘Statement of calculation of earnings available to equity holders and debt holders Particulars Company A B Net operating income 15,00,000 15,00,000 Less: Interest on Debt (11% of Rs.7,00,000) 2 77,000 Profit before taxes. 44,23,000 CA Inter_39e_F.M_Capital Structure_Assignment Solutions 4.13Ph: 9885125025/26 www.mastermindsindia.com Less: Tax @ 25% 15,00,000 3,585,750 Profit after tax/Earnings available in equity holders 3,75,000 10,67,250 Total earnings available to equity holders + Debt holders 14,25,000 | 40,67,250+77,000 14,25,000 =11,44,250 ‘As we can see that the earnings in case of Company B is more than the earnings of Company A because of tax shield available to shareholders of Company B due to the presence of debt structure in Company B. The interest is deducted from EBIT without tax deduction at the corporate level; equity holders also get their income after tax deduction due to which income of both the investors increase to the extent of tax saving on the interest paid i.e. tax shield i,e.25% x 77,000 = 19,250 i.e. difference in the income of two companies’ earnings i.e. 11,44,250- 11,25,000 = Rs. 19,250. PROBLEM NO: 26 Calculation of Value of Firms P and Q according to MM Hypothesis. Market Value of Firm P (Unlevered) EBIT(1-t) _ Rs2,60,000(1-0.30) _ Rs182,000 Vu= eo =Rs18,20000 Ke 10% 10% Market Value of Firm Q (Levered) Vo =W+TB SS & Copyrights Reserved ‘To MASTER MINDS, Guntur = Rs18,20,000 + (Rs 8,00,000 x 0.30) = Rs18,20,000 s 2,40,000 = Rs 20,60,000 CA Inter_39e_F.M_Capital Structure_Assignment Solutions 4.14