Capital Structure Theories: Numericals 1

Q1. X company has a net operating income of Rs. 2, 00,000 on an investment of Rs.
10, 00,000 in assets. It can raise debt at a 16% rate of interest. Assume that taxes do
not exist.
(a) Using the NI approach and an equity-capitalization rate of 18% compute the total
value of the firm and the weighted average cost of capital if the firm has no (i) no
debt, (ii) Rs.3,00,000 debt, (iii) Rs.6,00,000 debt.
(b) Using the NOI approach and an overall capitalization rate of 12 percent, compute the
total value of the firm, value of shares and the cost of equity if the firm has (i) no
debt, (ii) Rs.3,00,000 as debt, (iii) Rs.6,00,000 debt

Q2. Firm L and firm U are in same risk class and are identical in every respect except that firm L
is levered and firm U is unlevered. Firm L has 12% Rs. 4,00,000 debentures outstanding. Both
firms earn 18% before interest and taxes on their total assets of Rs. 8,00,000. Assume a corporate
tax rate of 50 percent and a pure equity capitalization rate of 15 percent.
(a) compute the total value of the firms using NI approach and NOI approach
(b) using the NOI approach calculate the after tax weighted average cost of capital for both
the firms. Which of the two firms has an optimum capital structure and why?

Q3. A new company proposes to invest Rs. 10 lakh in assets and will maintain its capital
structure at book value. It is expected to earn a net operating income of Rs. 1,60,000. The
company wants to have an optimum mix of debt and equity. The cost of debt and the equity-
capitalization rate at different debt equity ratio are as follows:
Debt-Equity Ratio Cost of Debt Equity Capitalization Rate
----- ------ 0.125
10:90 0.05 0.130
20:80 0.05 0.136
30:70 0.06 0.143
40:60 0.07 0.160
50:50 0.08 0.180
60:40 0.10 0.200
(a) what is the optimum capital structure of the company ?
(b) if MM hypothesis is valid what should be the equity capitalization rate at different debt
equity ratios?

Q4. The value for the two firms X and Y in accordance with the traditional theory are
given below:- No corporate taxes. Equilibrium value of Ko is 12.5%
X (Rs.) Y (Rs.)
Expected net operating income 50,000 50,000
Total cost of debt (INT) 0 10,000
Net income 50,000 40,000
Cost of equity 0.10 0.11
Market value of shares 5,00,000 3,60,000
Market value of debt 0 2,00,000
Total value of the firm 5,00,000 5,60,000
Average cost of capital 0.10 0.09
Debt equity ratio 0 0.556

1
Compute the values for firms X and Y as per MM thesis.
Q5. Following are the equilibrium value for two firms M and N as per the MM approach
M (Rs.) N (Rs.)
Expected net operating income 12,000 12,000
Total cost of debt (INT) 0 2000
Net income 12,000 10,000
Overall capitalization rate 0.08 0.08
Total value of the firm 1,50,000 1,50,000
Market value of debt 0 40,000
Market value of shares 1,50,000 1,10,000
Cost of debt 0 0.05
Cost of equity 0.08 0.091

Recompute the values for firms M and N in accordance with the traditional theory. Assume that
the cost of equity of firm M is 10% and for firm N it is 10.5%

Q6. Firm L and U have same expected EBIT of Rs. 25,000. Firm U has employed 100% equity
of Rs 1,00,000 while firm L has employed Rs, 50,000 equity and Rs. 50,000 debt at an expected
rate of return (cost of debt) of 15% You are required to calculate for each firm:
(a) earnings of all investors
(b) value of interest tax shield under the following alternatives (i) no corporate and personal
taxes (ii) 50% corporate and zero personal taxes (iii)50% corporate taxes and 30%
personal taxes (iv) 50% corporate taxes and 20% personal taxes on dividend income and
40% personal taxes on interest income.

Q7. The net operating income of XYZ Ltd is Rs.50,000 The cost of debt is 12% . Outstanding
debt is Rs. 2,00,000 If the overall capitalization rate (overall cost of capital) is 12.5% what
would be the total value of the firm and the equity capitalization rate ? Also verify the validity
of the NOI approach

Q8. Assume that there are two firms A and B which are identical in all respects except that firm
A has 12% Rs. 6,00,000 debentures. The earnings before interest and taxes of both the firms are
equal i.e. Rs.1,25,000. The equity capitalization rate of the firm A is slightly higher (16%) than
that of firm B (14%) Comment ofn the same assuming the MM hypothesis.

Q9. The following is the information available for Arvind Regulators

Net operating income Rs. 50 lakhs; Interest on debt Rs. 12 lakhs; Cost of equity 18%; Cost
of debt 12%. Compute (i) average cost of capital (ii) what happens to average cost of capital if it
employs 120 lakh debt to finance a project which earns an operating income of Rs. 40 lakhs.
Assume the net operating income NOI method applied and that there are no taxes.

Q10. Calculate operating leverage and financial leverage under situations A,B,C and
financial plan 1,2,3 respectively from the following information relating to the
operations and capital structure of XYZ company
Installed capacity 1200 units. Actual production and sales 800 units. Selling Pricing per unit
Rs.15. Variable cost per unit Rs.10. Fixed cost for situation A= Rs.1000, B=Rs.2000, C = Rs.
3000.
Capital Structure I II III
2
 Equity (Rs.) 5000 7500 2500
Debt (Rs.) 2500 2500 7500
Cost of debt 12 %

Q11. The sales revenue of Leveret Company @ Rs.20 per unit of output is Rs. 20 lakhs
and contribution is Rs. 10 lakhs. At the present level of operations the DOL of the company
the company is 2.5 . The company does not have any preference shares. The number of ordinary
shares is 1 lakh. Applicable corporate tax rate is 50% and the rate of interest on debt capital is
16% p.a. What are the EPS (at sales revenue of Rs. 20 lakhs) and amount of debt capital of the
company is a 25% decline in sales will wipe out EPS ?

Q12. The operating and total leverage of Engima company are 2 and 5 respectively. Total
variable cost at the existing level of operations amount to Rs. 6,50,000 Interest expenses
and dividend on preference shares are Rs.75,000 and Rs.36,000 Interest expenses and dividend
on preference shares are Rs. 75,000 and Rs. 36,000 respectively. Corporate income tax is 60%
What is the sales revenue of the company ?

Q13. A company’s present book value capital structure is as follows: (8 Marks)

Debentures ( @ Rs.100 each ) Rs.700000
Preference shares (@ Rs.100 each) Rs. 300000
Equity shares (@ Rs. 10 each) Rs.1000000
Rs. 2000000
All these securities are traded in the capital market and their recent prices are:
Debentures Rs. 110 per debenture, Preference share Rs. 120 per preference share, Equity share
Rs. 22 per share. Anticipated external financing opportunities are as follows
 Rs. 100 redeemable debenture at face value after 8 years, 13% interest rate, 4% flotation cost.
 14% redeemable preference share (5 years), it involves a flotation cost of 5% and the sale
price is Rs.100
 Equity share Rs 2 per share brokerage will fetch Rs.22
In addition the dividend expected as the equity share at the end of the year is Rs.2 per share. The
anticipated growth rate in dividends is 6% and the firm has the practice of paying all its earnings
in the form of dividends. The corporate tax rate is 35%. You are required to calculate WACC
using book and market values.

Q14. A levered company and a unlevered company are identical in every respect except that the
levered company has 6% Rs.2, 00,000/- debt outstanding. As per the NI approach, the valuation
of two firms is as follows.
Unlevered Company Levered Company
NOI 60,000 60,000
Cost of Debt 0 12%
Net Earnings 60,000 48,000
Equity Capitalization Rate 10% 11.1%
Market Value of Equity 6,00,000 4,32,000
Market Value of Debt 0 2,00,000
Total Value of Firm 6,00,000 6,32,000

3
Mr. X holds Rs.2,000/- worth of the levered company’s shares. Is it possible for Mr. X to reduce
his outlay to earn same return through the use of arbitrage? Illustrate.
Q15. A firm in the business of manufacturer of automobile components is considering two
mutually exclusive technologies for manufacturer of a hydraulic brakes. These two technologies
are designated as Option A and Option B with project cost of Rs.1600 lakh and Rs. 1850 lakh.
Depending upon the various features of the product obtainable from the two technologies the
firm has developed a forecast of cash flows for 5 years . These cash flows are as follows
Amount in Lakh
Year Option A Option B
1 350 675
2 475 575
3 625 725
4 575 350
5 350 400
Option A is a familiar technology and therefore the firm feels that the current cost of capital of
13% is the appropriate discount rate. However, Option B is considered riskier than the Option A
and therefore firm would like to use a discount rate of 15% . Your are required to calculate (i)
NPV for A and B, (ii) IRR for A and B, (iii) which option you will consider with NPV rule and
IRR rule, (iv) Firm believes that under most probable circumstances it would be able to re-invest
the internally generated cash flows of the project at 14%. What would be your decision in that
case.

Q16. Indore Stove Company is considering a new product line to supplement its range line. It is
anticipated that the new product line will involve cash investment of Rs. 70,000/- at time 0 and
Rs 1.0 million in Year 1. After tax cash inflows of Rs. 2,50,000/-are expected in year 2, Rs.
3,00,000/- in year 3, Rs. 3,50,000/- in year four and Rs. 4,00,000/- thereafter through year 10.
While the product line might be viable after ten years the company prefers to be conservative and
end all its calculations at that time. If required rate of return is 15% what is the NPV of the
project? Is it acceptable? What is the IRR of the project? What is the Payback Period of the
project?

Q17. The following information was taken from the financial statements of XYZ Ltd. (amount in
thousands of rupees). Calculate those ratios which indicate the efficient use of assets and discuss potential
sources of trouble.
Particulars Year 1 Year 2 Year 3
Total assets 750 850 860
Credit sales 420 520 550
Cost of goods sold 450 595 645
Cash 50 60 55
Debtors 150 165 180
Inventory 130 160 170
Net fixed assets 120 260 250
Creditors 75 85 100
Short term debt 125 175 170
Long term debt 125 185 175
Equity 125 200 210
Q18. X Coating company has hired u as financial consultant to advise the company with respect
to its dividend policy. The coating industry has been very stable for quite some time and the
firm’s stock has not appreciated significantly in market value for several years. The rapidly
4
growing southeastern markets provide an excellent opportunity for this old traditionally mid
western coating manufacturer to undertake an expansion program. To do this the company has
decided to sell common equity shares in the near future. The company expects its entrance into
the southeastern markets will be profitable returning approximately 25% on investment each
year. Data on earnings dividends and common stock prices are given below:
2010 2011 2012 2013 Anticipated
2014
EPS 4.32 4.17 4.16 4.80 4.75
DPS 2.90 2.80 3.00 3.20 ????
Payout Ratio 67% 67% 65% 67% ????
Av. Mkt 60 58 60 67 66
Price
P/E Ratio 14/1 14/1 13/1 14/1

Q19. Estimate the net working capital for the firm from the given figures. Add 10/% to your
computed figure to allow for contingencies.
Estimated cost per unit of production
Raw Material Rs. 80
Direct Labor 30
Overheads (including depreciation of Rs. 5) 65
Total 175
Additional Information
 Selling Price Rs. 200 per unit ; Level of activity 1,04,000 units per annum
 RM in stock average 4 weeks
 WIP (assume full unit of raw material required in the beginning of manufacturing; other
conversion costs are 50%) average 2 weeks
 Finished goods in stock average 4 weeks; Credit allowed by suppliers average 4 weeks
 Credit allowed to debtors average 8 weeks ; Time lag in payment of wages 1.5 weeks
 Cash in bank (desired to be maintained) Rs. 25,000/-
 All sales on credit basis ; No of weeks in an year are 52.

Q20. From the following capital structure of XYZ Ltd. Determine appropriate weighted average
cost of capital.
Equity Shares (1,00,000) Rs. 38,00,000
Preference Shares 8,00,000
Debentures 50,00,000
Long Term Bank Loan 18,00,000
Short Term Bank Loan 14,00,000
Trader Creditors 6,00,000
 Equity shares include the existing 60,000 shares having current market value of Rs. 40 per
share and the balance is net proceeds from the new issue in the current year (issue price of
share is Rs. 40, flotation cost per share Rs. 5) The projected EPS and DPS for the current
year are Rs. 8 and Rs 5 respectively.
 Dividend indicated on preference share is 16%
 Pre tax cost of debenture 15.5%
 Interest on bank loan 15% (long term) and 14% (short term)

5
 Corporate Tax 35%; Dividend Tax 10%
 Market Value of Preference shares is Rs.8,50,000/-