CAPITAL STRUCTURE CA SUNIL KESWANI 1

Capital Structure
Question - 1
SK Ltd. has equity share capital of `5,00,000 (face value `100). To meet the expenditure of
an expansion programme, the company wishes to raise `3,00,000 and is having following four
alternative sources to raise the funds:
Plan A: To have full money from the equity shares
Plan B: To have `1 lakh from equity and `2 lakhs from borrowing from the financial
institutions @ 10% p.a.
Plan C: Full money from borrowing @ 10% per annum
Plan D: `1 lakh in equity and `2 lakh from preference shares @ 8% per annum dividend.
The company is having present earnings (EBIT) of `1,50,000. The corporate taxes 50%.
Suggest a suitable plan of the above four plans to raise the required funds.

Question - 2
SK Ltd. requires `25,00,000 for a new plant. This plant is expected to yield earnings before
interest and taxes of `5,00,000. While deciding about the financial plan, the company
considers the objective of maximizing earnings per share.

It has three alternatives to finance the project – by raising debt of

`2,50,000 or `10,00,000 or `15,00,000 and the balance in each case by
issuing equity shares. The company’s share is currently selling at `150,
but is expected to decline to `125 in case the funds are borrowed in
excess of `10,00,000. The funds can be borrowed at the rate of 10% up
to `2,50,000, at 15% over `2,50,000 and up to `10,00,000 and at 20%
over `10,00,000. The tax rate applicable to the company is 50 percent.
Analyse which form of financing should the company choose?

Question - 3
SK Ltd., a profit making company, has a paid-up capital of `100 lakhs consisting of 10 lakhs
ordinary shares of `10 each. Currently, it is earning an annual pre-tax profit of `60 lakhs. The
company’s shares are listed and are quoted in the range of `50 to `80. The management wants
to diversify production and has approved a project which will cost `50 lakhs and which is
expected to yield a pre-tax income of `40 lakhs per annum. To raise this additional capital, the
following options are under consideration of the management:
(a) To issue equity share capital for the entire additional amount. It is expected that the new
shares (face value of `10) can be sold at a premium of `15.
(b) To issue 16% non-convertible debentures of `100 each for the entire amount.

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 CAPITAL STRUCTURE CA SUNIL KESWANI 2
(c) To issue equity capital for `25 lakhs (face value of `10 each) and 16% noon-convertible
debentures for the balance amount. In this case, the company can issue shares at a premium
of `40 each.
Calculate the additional capital that can be raised, keeping in mind that the management wants
to maximise the earnings per share to maintain its goodwill. The company is paying income
tax at 50%.

Question - 4
The following data are presented in respect of SK Ltd.:
Particulars Amount (`)
Profit before interest and tax 52,00,000
Less: Interest on debentures @12% 12,00,000
Profit before tax 40,00,000
Less: Income tax @ 50% 20,00,000
Profit after tax 20,00,000
No. of equity shares (of `10 each) 8,00,000
EPS 2.5
MPS 25
The company is planning to start a new project requiring a total capital outlay of `40,00,000.
You are informed that a debt equity ratio (D/D+E) higher than 35% push the Ke up to 12.5%
means reduce PE ratio to 8 and rises the interest rate on additional amount borrowed at 14%..
Find out the probable price of share if:
(a) the additional funds are raised as a loan.
(b) the amount is raised by issuing equity shares.
(Note: Retained earnings of the company is `1.2 crores).

Question - 5
Suppose that a firm has an all equity capital structure consisting of 1,00,000
ordinary shares of `10 per share. The firm wants to raise `2,50,000 to
finance its investments and is considering three alternative methods of
financing – (i) to issue 25,000 ordinary shares at `10 each, (ii) to borrow
`1,50,000 at 8 percent rate of interest, (iii) to issue 2,500 preference shares
of `100 each at an 8 percent rate of dividend. If the firm’s earnings before
interest and taxes after additional investment are `3,12,500 and the tax rate
is 50 percent, find the effect on the earnings per share under the three
financing alternatives.

Question - 6
SK Limited requires funds amounting to `80 lakhs for its new project. To raise the funds, the
company has following alternatives:
(i) To issue equity shares of `100 each (at par) amounting to `60 lakhs and borrow the
balance amount at the interest of 12% p.a.; or
(ii) To issue equity shares of `100 each (at par) and 12% debentures in equal proportion.

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 CAPITAL STRUCTURE CA SUNIL KESWANI 3
The income tax rate is 30%. Identify the point of indifference between the available two modes
of financing and state which option will be beneficial in different situations.

Question - 7
SK Ltd. is setting up a project with a capital outlay of `60,00,000. It has two alternatives in
financing the project cost.

Alternative – 1: 100% equity finance by issuing equity shares of `10 each.

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

The rate of interest payable on the debt is 18% p.a. The corporate tax rate is 40%. Calculate
the indifference point between the two alternative methods of financing.

Question - 8
SK Ltd. is considering three financing plans. The key information is as follows:
(a) Total investment to be raised `2,00,000
(b) Plans of financing portion
Plans Equity Debt Preference
A 100% - -
B 50% 50% -
C 50% - 50%
(c) Cost of debt 8%
Cost of preference shares 8%
(d) Tax rate 50%
(e) Equity share of the face value of `10 each will be issued at a premium
of `10 per share
(f) Expected EBIT is `80,000.
You are required to determine for each plan:
(i) Earning per share (EPS)
(ii) The financial break-even point
(iii) Indicate if any of the plans dominate and compute EBIT range
among the plans for indifference.

Question - 9
SK Ltd. is considering a new project which requires a capital investment of `9 crores. Interest
on term loan is 12% and corporate tax rate is 30%. Calculate the point of indifference for the
project considering the Debt Equity ratio insisted by the financing agencies being 2:1.

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 CAPITAL STRUCTURE CA SUNIL KESWANI 4
Question - 10
SK Ltd. is considering two alternative financing plans as follows:
Particulars Plan – A (`) Plan – B (`)
Equity shares of `10 each 8,00,000 8,00,000
Preference Shares of `100 each - 4,00,000
12% Debentures 4,00,000 -
12,00,000 12,00,000
The indifference point between the plans is `4,80,000. Corporate tax rate is 30%. Calculate
the rate of dividend on preference shares.

Question - 11
SK Limited presently has `36,00,000 in debt outstanding bearing an
interest rate of 10 percent. It wishes to finance a `40,00,000 expansion
programme and is considering three alternatives; additional debt at 12
percent interest, preference shares with an 11 percent dividend, and the
issue of equity shares at `16 per share. The company presently has
8,00,000 shares outstanding and is in a 40 percent tax bracket.
(a) If earning before interest and taxes are presently `15,00,000.
Determine earnings per share for the three alternatives, assuming no
immediate increase in profitability.
(b) Analyse which alternatives do you prefer. Compute how much would EBIT need to
increase before the next alternative would be best.

Question - 12
SK Ltd.’s EBIT is `5,00,000. The company has 10%, `20 lakh debentures. The equity
capitalization rate i.e. ke is 16%.
You are required to calculate:
(i) Market value of equity and value of firm
(ii) Overall cost of capital

Question - 13
SK Ltd. has EBIT of `1,00,000. The company make use of debt and equity capital. The firm
has 10% debentures of `5,00,000 and the firm’s equity capitalization rate is 15%.
You are required to calculate:
(a) Current value of the firm
(b) Overall cost of capital

Question - 14
SK Ltd., is expecting an EBIT of `3,00,000. The company presently raised its entire fund
requirement of `20 lakhs by issue of equity with equity capitalization rate of 16%. The firm is
now contemplating to redeem a part of capital by introducing debt financing. The firm has two
options to raise debt to the extent of 30% or 50% of total funds. It is expected that for debt

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 CAPITAL STRUCTURE CA SUNIL KESWANI 5
financing upto 30% the rate of interest will be 10% and equity capitalization rate is expected
to increase to 17%. However, if firm opts for 50% debt then interest rate will be 12% and equity
capitalization rate will be 20%. You are required to compute value of firm and its overall cost
of capital under different options if the traditional approach is held valid.

Question - 15
SK Ltd. is expecting an Earnings before interest & tax of `4,00,000 and is an all equity
company.
(a) Using the NOI approach and an overall cost of capital of 10%, compute
the total value, the stock market value of the firm, and the cost of equity.
(b) Determine the answers to (a) if the company decide to retire `1 million
of common stock it with 9% long term debt. Also compute the return
of Mr. S if he owns 5% of the shares of SK Ltd.

Question - 16
Alpha Ltd. and Beta Ltd. are identical except for capital structures. Alpha Ltd. has 50 percent
debt and 50 percent equity, whereas Beta Ltd. has 20 percent debt and 80 percent equity. (All
percentages are in market-value terms). The borrowing rate for both companies is 8 percent in
a no-tax world, and capital markets are assumed to be perfect.
(a) (i) If you own 2 percent of the shares of Alpha Ltd., determine your return if the
company has net operating income of `3,60,000 and the overall capitalization rate of
the company, Ko is 18 percent?
(ii) Calculate the implied required rate of return on equity.
(b) Beta Ltd. has the same net operating income as Alpha Ltd.
(i) Determine the implied required return of Beta Ltd.?
(ii) Analyse why does it differ from that of Alpha Ltd.?

Question - 17
SK Ltd. has a total capitalization of `10,00,000. The financial manager of the firm wants to
take a decision regarding the capital structure. After a study of the capital market, he gathers
the following data:
Amount of Debt Interest Rate Equity Capitalization Rate
` % (at given level of debt) %
0 - 10.0
1,00,000 4.0 10.5
2,00,000 4.0 11.0
3,00,000 4.5 11.6
4,00,000 5.0 12.4
5,00,000 5.5 13.5
6,00,000 6.0 16.0

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 CAPITAL STRUCTURE CA SUNIL KESWANI 6
(a) What amount of debt should be employed by the firm if the traditional approach is held
valid (and that the firm always maintains its capital structure at book values)?
(b) If the Modigliani-Millar approach is followed, what should be the equity capitalization
rate?

Question - 18
There are two company N Ltd. and M Ltd., having same earnings before
interest and taxes i.e. EBIT of `20,000. M Ltd. is a levered company having
a debt of `1,00,000 @7% rate of interest. The cost of equity of N Ltd. is
10% and of M Ltd. is 11.50%. Compute how arbitrage process will be
carried on?

Question - 19
Following data is available in respect of two companies having same business risk:
Capital employed = `2,00,000; EBIT = `30,000 Ke = 12.5%
Sources Levered Company (`) Unlevered Company (`)
Debt (@10%) 1,00,000 NIL
Equity 1,00,000 2,00,000
Investor is holding 15% shares in levered company. Calculate increase in annual earnings of
investor if he switches his holding from levered to unlevered company.

Question - 20
There are two companies U Ltd. and Ltd., having same NOI of `20,000 except that L Ltd. is
a levered company having a debt of `1,00,000 @7% and cost of equity of U Ltd. and L Ltd.
are 10% and 18% respectively. Compute how arbitrage process will work.

Question - 21
Following data is available in respect of two companies having same business risk:
Capital employed = `2,00,000; EBIT = `30,000
Sources Levered Company (`) Unlevered Company (`)
Debt (@10%) 1,00,000 NIL
Equity 1,00,000 2,00,000
Ke 20% 12.5%
Investor is holding 15% shares in Unlevered company. Calculate increase in annual earnings
of investor. If he switches his holding from Unlevered to Levered company.

Question - 22
Companies Chunnu and Munnu are identical in every respect except that the former does not
use debt in its capital structure, while the latter employs `6,00,000 of 15% debt. Assuming
that (a) all the MM assumptions are met, (b) the corporate tax rate is 50%, (c) the EBIT is

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 CAPITAL STRUCTURE CA SUNIL KESWANI 7
`2,00,000, and (d) the equity capitalization of the unlevered company is 20%, what will be the
value of the firms, Chunnu and Munnu? Also determine the weighted average cost of capital
for both the firms.

Question - 23
Determine the optimal capital structure of a company from the following information:
Options Cost of Debt (Kd) Cost of Equity (Ke) Percentage of Debt on total
in % in % value (Debt + Equity)
1 11.0 13.0 0.0
2 11.0 13.0 0.1
3 11.6 14.0 0.2
4 12.0 15.0 0.3
5 13.0 16.0 0.4
6 15.0 18.0 0.5
7 18.0 20.0 0.6

Question - 24
SK Ltd.’s operating income (EBIT) is `5,00,000. The firm’s cost of debt is 10% and currently
the firm employs `15,00,000 of debt. The overall cost of capital of the firm is 15%. You are
required to calculate:
(a) Total value of the firm
(b) Cost of Equity

Question - 25
SK Ltd., an all equity financed company is considering the repurchase of
`275 lakhs equity shares and to replace it with 15% debentures of the
same amount. Current market value of the company is `1,750 lakhs with
its cost of capital of 20%. The company’s Earnings before Interest and
Taxes (EBIT) are expected to remain constant in future years. The
company also has a policy of distributing its entire earnings as dividend.

Assuming the corporate tax rate as 30%, you are required to calculate the
impact on the following on account of the change in the capital structure as per Modigliani and
Miller (MM) Approach:
(a) Market value of the company
(b) Overall cost of capital
(c) Cost of Equity

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Question - 26
One-third of the total market value of SK Ltd. consists of loan stock,
which has a cost of 10 percent. Another company MK Ltd., is identical
in every respect to SK Ltd., except that its capital structure is all-equity,
and its cost of equity is 16 percent. According to Modigliani and Miller,
if we ignored taxation and tax relief on debt capital, compute the cost of
equity of SK Ltd.

Question - 27
The following data relates to two companies belonging to the same risk class:
Particulars A Ltd. B Ltd.
Expected Net Operating Income `18,00,000 `18,00,000
12% Debt `54,00,000 -
Equity capitalization rate - 18
Required:
(a) Determine the total market value, equity capitalization rate and weighted average cost of
capital for each company assuming no taxes as per M.M. approach.
(b) Determine the total market value, equity capitalization rate and weighted average cost of
capital for each company assuming 40% taxes as per MM Approach.

Question - 28
The following particulars relating to SK Ltd. for the year ended 31st March 2022 is given:
Output 1,00,000 units at normal capacity
Selling price per unit `40
Variable cost per unit `20
Fixed cost `10,00,000
The capital structure of the company as on 31st March, 2022 is as follows:
Particulars `
Equity share capital (1,00,000 shares of `10 each) 10,00,000
Reserve and Surplus 5,00,000
7% debentures 10,00,000
Current liabilities 5,00,000
Total 30,00,000
SK Ltd. has decided to undertake an expansion project to use the market potential, that will
involve `10 lakhs. The company expects an increase in output by 50%. Fixed cost will be
increase by `5,00,000 and variable cost per unit will be decreased by 10%. The additional
output can be sold at the existing selling price without any adverse impact on the market.

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 CAPITAL STRUCTURE CA SUNIL KESWANI 9
The following alternatives schemes for financing the proposed expansion programme are
planned:
(i) Entirely by equity shares of `10 each at par.
(ii) `5 lakh by issue of equity shares of `10 each and the balance by issue of 6% debentures
of `100 each at par.
(iii) Entirely by 6% debentures of `100 each at par.
Find out which of the above-mentioned alternatives would you recommend for SK Ltd. with
reference to the risk and return involved, assuming a corporate tax of 40%.

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