FINANCIAL MANAGEMENT

Module 3: Financing Decisions - Capital Structure

1. Following are the details regarding A Ltd.
Share capital
Equity (Rs. 10) Rs. 1,00,000
10% Preference share (Rs. 10) Rs. 50,000
10% Debentures Rs. 1,00,000
Tax rate 40%
Earnings before interest and tax (EBIT) Rs. 18,333
Calculate EPS:
a. At present level of EBIT.
b. If EBIT increases to Rs. 25,000.
c. If EBIT increases to Rs. 35,000.

2. Penta Four Ltd. has currently an all equity shares consisting of 15,000 equity shares of
Rs. 100 each. The management is planning to raise another Rs. 25,00,000 to finance a
major programme of expansion and is considering three alternative methods of
financing:
a. To issue 25,000 equity shares of Rs. 100 each.
b. To issue 25,000, 8% debentures of Rs. 100 each.
c. To issue 25,000, 8% preference shares of Rs. 100 each.
The company’s expected earnings before interest and tax (EBIT) will be Rs. 8,00,000.
Assuming corporate tax rate is 50%. Determine the earnings per share (EPS) in each
alternative and comment which alternative is best and why?

3. A manufacturing company has the following capital structure:

Particulars Amt.
40,000 equity shares of Rs. 50 each 20,00,000
Retained earnings 10,00,000
10% debentures 10,00,000
12% preference shares 10,00,000
Long Term Debt at 11% 5,00,000
55,00,000
The present EBIT is Rs. 10,00,000. The company is contemplating an expansion
programme requiring an additional investment of Rs. 10,00,000. It is hoped that the
company will be able to maintain the same level of earnings. To raise the additional
capital the company has the following alternatives:
a. To issue debentures at 11%
b. To issue preference shares at 13%
c. To raise the entire additional capital through equity shares
Examine these alternatives and suggest which alternative is best for the company.
Assume tax rate at 35%.
4. A firm has sales of 1,00,000 units at Rs. 10 p.u. Variable cost of the produced
products is 60% of the total sales revenue. Fixed cost is Rs. 2,00,000. The firm has
used a debt of Rs. 5,00,000 at 20% interest. Calculate the Operating leverage,
Financial leverage, combined leverage and interpret the same.

5. A firm has sales of Rs. 10,00,000, variable cost Rs. 7,00,000, fixed cost of Rs.
2,00,000 and debt of Rs. 5,00,000 at 10% rate of interest. Calculate operating
leverage, financial leverage and combined leverage.

6. Following is the information from ABC Ltd. calculate F.L., O.L. and C.L. if the
number of units sold is 20,000, Selling price p.u. is Rs. 60, Variable cost Rs. 40 p.u.,
Fixed cost is Rs. 6,00,000, Interest burden Rs. 2,00,000, Tax rate 50% and preference
dividend Rs. 1,00,000.

7. Calculate O.L., F.L. and C.L. from the following data.

Sales (1,00,000 units) 2,00,000
Variable cost 0.70 p.u.
Fixed cost 65,000
Interest charges 15,000

8. Calculate financial leverage and Operating leverage of the two firms and find which
has greater business and financial risk.
Particulars Firm A Firm B
Sales (Rs.) 20,00,000 30,00,000
Variable cost 40% of sales 30% of sales
Fixed cost 5,00,000 7,00,000
Interest 1,00,000 1,25,000

9. From the following particulars of ABC Ltd., calculate degree of operating leverage.

Particulars Previous year 2021 Current year 2022

Sales revenue 10,00,000 12,50,000
Variable cost 6,00,000 7,50,000
Fixed cost 2,50,000 2,50,000

10. The capital structure of a company consists of the following securities:

10% preference share capital Rs. 1,00,000
Equity share capital (Rs. 10 shares) Rs. 1,00,000
The amount of operating profit is Rs. 60,000. The company is in 50% tax bracket.
You are required to calculate the degree of financial leverage of the company if the
operating profit increases to Rs. 90,000.

11. The following data are available for X Ltd.

Selling price per unit Rs. 120
 Variable cost per unit Rs. 70
Total fixed cost Rs. 2,00,000
a. What is the operating leverage where X Ltd. Produces and sells 6,000 units?
b. What is the degree of Operating Leverage if output increases by 5%?

12. From the following particulars of PQR Company, calculate degree of operating and
financial leverages. The company’s current sales revenue is Rs. 15,00,000 and sales
are expected to increase by 25%. Rs. 9,00,000 incurred on variable expenses for
generating Rs. 15,00,000 sales revenue. The fixed cost is Rs. 2,50,000. The company
has Rs. 20,00,000 equity share capital and Rs. 20,00,000, 10% debt capital. Rs. 10 per
equity share and 50% tax rate.

13. A company has sales of Rs. 1,00,000. The variable costs are 40% of the sales while
the fixed operating costs amount to Rs. 30,000. The amount of interest on long term
debt is Rs. 10,000. You are required to calculate all the leverages if sales increases by
5%.

14. The capital structure of Progressive Corporation consists of an ordinary share capital
of Rs. 10,00,000 (shares of Rs. 100 par value) and Rs. 10,00,000 at 10% debentures.
Sales increased by 20% from 1,00,000 units to 1,20,000 units, the selling price is Rs.
10 per unit, variable cost amounts to Rs. 6 per unit and fixed expenses amount to Rs.
2,00,000. The income tax rate is assumed to be 50%.
You are required to calculate the following:
a. The percentage increase in earnings per share.
b. The financial leverage at 1,00,000 units and 1,20,000 units.
c. The operating leverage at 1,00,000 units and 1,20,000 units.
Comment on the behaviour of operating and financial leverages in relation to increase
in production from 1,00,000 units to 1,20,000 units.

15. A firm has sales of Rs. 10,00,000, V.C. Rs. 7,00,000 and F.C, Rs. 2,00,000. Debt is
Rs. 5,00,000 at 10% rate of interest. What are its OL and FL? What is the required
percentage increase in sales to double the EBIT?

16. A private company has a EBIT of Rs. 4,80,000 and its capital structure consists of the
following securities:
Equity share capital (Rs. 100 each) Rs. 4,00,000
12% preference shares of Rs. 6,00,000
14.5% debentures Rs. 10,00,000
Corporate tax rate 35%
The company is facing fluctuation in its sales. What would be the change in EPS?
 If EBIT of the company increases by 25%
 If EBIT decreases by 20%
17. A company has the following capital structure:
10,000 equity shares of Rs. 10 each Rs. 1,00,000
2,000, 10% preference shares of Rs. 100 each Rs. 2,00,000
2,000, 10% debentures of Rs. 100 each Rs. 2,00,000
Calculate the EPS for each of the following levels of EBIT: (i) Rs. 1,00,000, (ii) Rs.
60,000 and (iii) Rs. 1,40,000. The company is in 50% tax bracket. Also calculate the
percentage change in EPS associated with 40% increase and 40% decrease in EBIT.

18. Calculate the OL, FL and CL from the following data under situation I and II and
financial plans A and B.

Installed capacity 40,000 units

Actual production and sales 75% of capacity
Selling price Rs. 30 per unit
Variable cost Rs. 15 per unit
Fixed cost: Situation I Rs. 1,50,000
Situation II Rs. 2,00,000
Capital structure Financial plan A Financial plan B
Equity 10,00,000 15,00,000
Debt (20% rate of interest) 10,00,000 5,00,000

19. Calculate FL and OL under situation A and B and for financial plans I and II
respectively from the following relating to the operations and capital structure of ABC
ltd.

Installed capacity 1,000 units

Actual production and sales 800 units
Selling price per unit Rs. 20
Variable cost per unit Rs. 15
Situation A Situation B
Fixed costs Rs. 800 Rs. 1,500
Capital structure Plan I Plan II
Equity capital Rs. 5,000 Rs. 7,000
Debt Rs. 5,000 Rs. 2,000
Cost of debt @ 10%

20. From the following financial data of companies A, B and C prepare their income
statements.

Particulars A B C
Variable cost as a % of sales 66 2/3 75 50
Interest expense Rs. 200 Rs. 300 Rs. 1000
OL 5 6 2
FL 3 4 2
Income tax rate 50% 50% 50%

21. The following is the balance sheet of Venson Ltd. as on 31-3-2014

 Liabilities Amt. Assets Amt.
Equity capital (Rs. 10 per 1,80,000 Fixed assets 4,50,000
share) Current assets 1,50,000
10% debentures 2,40,000
Retained earnings 60,000
Current liability 1,20,000
6,00,000 6,00,000
The company’s total assets turnover ratio is 2.5 times. The fixed operating costs are
Rs. 2,00,000. Variable operating cost ratio is 40%. Income tax rate is 50%.
(i) Calculate the leverages.
(ii) Determine the likely level of EBIT if EPS is Rs. 6

22. A company plans to raise Rs. 30,00,000 for its new project. It can raise the sales by 2
options:
a. Entire amount by equity.
b. Rs. 15,00,000 by 10% debt and balance by equity.
Calculate the indifference point assuming tax rate is 35% and par value of the
share is Rs. 100.

23. A firm requires Rs. 5,00,000 for its immediate financial plan.
a. Either to raise the entire amount through equity shares.
b. Half of the amount through equity and the remaining half through 10% debt.
Tax rate is 50%. Face value of the share is Rs. 100. Calculate the indifference
point.

24. A project under consideration by a company requires a capital investment of Rs.

60,00,000. Interest on term loan (debentures) is 10% p.a. Tax rate is 50%. Calculate
the point of indifference if in the 1st plan, entire amount is raised through equity and in
the 2nd plan, debt-equity ratio is 2:1. Face value of the share is Rs. 10.

25. P Ltd. has the following Balance sheet and Income statement:
Balance sheet as on March 31st:
Liabilities Amt. Assets Amt.
Equity capital (Rs. 10) 8,00,000 Net Fixed Assets 10,00,000
10% Debt 6,00,000 Current Assets 9,00,000
Retained earnings 3,50,000
Current liabilities 1,50,000
19,00,000 19,00,000

Income statement for the year ending March 31st:

Particulars Amt.
Sales 3,40,000
(-)Operating expenses (including Rs.
60,000 Depreciation) 1,20,000
EBIT 2,20,000
(-) Interest 60,000
 EBT 1,60,000
(-) Taxes 56,000
EAT 1,04,000
a. Determine the degree of operating leverage, degree of financial leverage and
degree of combined leverage at the current sales level, if all operating expenses
other than depreciation are variable costs.
b. If total assets remain at the same level, but sales (i) increases by 20% and (ii)
decreases by 20%, what will be the EPS at the new sales levels?

26. If the combined leverage and operating leverage of a company are 2.5 and 1.25
respectively, find the financial leverage and P/V ratio, given that the equity dividend
per share is Rs. 2, interest payable per year is Rs. 1,00,000, total fixed cost Rs. 50,000
and sales Rs. 10,00,000.

27. You are a finance manager in Big Pen Ltd. The degree of operating leverage of your
company is 5 times. The degree of financial leverage is 3 times. Your managing
director has found that the degree of operating leverage and the degree of financial
leverage of your competitor Small Pen Ltd. is better than that of Big Pen Ltd. because
of higher value of degree of leverages. Do you agree with the opinion of your
managing director? Give reasons.

28. A Company needs Rs. 10 lakhs for the development of a new product. It will yield an
annual operating profit of Rs. 2,40,000. Share price is Rs. 50 each. The company has
the objective of maximising the earnings per share. Tax rate is 50%. Funds can be
raised at the following interest rates:
a. Upto Rs. 1,00,000 at 8%
b. Over Rs. 1,00,000 to Rs. 5,00,000 at 12%
c. Over Rs. 5,00,000 at 15%
The company has developed three financing plans that are given below:
i. Raise Rs. 1,00,000 debt with expected operating profit of Rs. 3,40,000.
ii. Raise Rs. 3 lakhs debt with expected operating profit of Rs. 440,000.
iii Raise Rs. 6 lakhs debt with expected operating profit of Rs. 590,000.
Calculate EPS for the above financial plans and give the best plan based on higher
EPS

****************************************