Chapter 3 - Capital Structure

Chapter 3
Financing Decisions - Capital Structure
Effects of Different Modes of Financing Leverage Effects – Maximizing EPS
Question 1 - Dec 2021
Earnings before interest and tax of a company are ₹ 4,50,000. Currently the company has 80,000 Equity shares
of ₹ 10 each, retained earnings of ₹ 12,00,000. It pays annual interest of ₹ 1,20,000 on 12% debentures. The
company proposes to take up an expansion scheme for which it needs additional funds of ₹ 6,00,000. It is
anticipated that after that after expansion, the company will be able to achieve the same return on investment
as at present. It can raise fund either through debts at rate of 12%p.a. or by issuing Equity share at par. Tax
rate is 40%.
Required:
Compute the earning per share if:
(i)The additional funds were raised through debts.
(ii)The additional funds were raised by issue of Equity Shares.
Advise whether the company should go for expansion plan and which sources of finance should be preferred.

Question 2 - Rtp Nov 2023

Prakash Limited provides you the following information:
(₹)
Profit (EBIT) 3,00,000
Less: Interest on Debenture @ 10% (50,000)
EBT 2,50,000
Less Income Tax @ 50% (1,25,000)
1,25,000
No. of Equity Shares (₹ 10 each) 25,000
Earnings per share (EPS) 5
Price /EPS (PE) Ratio 10
The company has reserves and surplus of ₹ 7,50,000 and required ₹ 5,00,000 further for modernisation. Return
on Capital Employed (ROCE) is constant. Debt (Debt/ Debt + Equity) Ratio higher than 40% will bring the P/E
Ratio down to 8 and increase the interest rate on additional debts to 12%. You are required to ASCERTAIN the
probable price of the share.
(i) If the additional capital is raised as debt; and
(ii) If the amount is raised by issuing equity shares at ruling market price

Question 3 - Study Material, Rtp

Goodluck Charm 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 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.
c) To issue equity capital for ₹ 25 lakhs (face value of ₹ 10) and 16% non-convertible debentures for the
balance amount. In this case, the company can issue shares at a premium of ₹ 40 each.

You are required to advise the management as to how the additional capital 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 - May 08
Delta Ltd. Currently has an Equity Share Capital of ₹ 10,00,000 consisting of 1,00,000 Equity Shares of ₹ 10
each. The company is going through a major expansion plan requiring to raise finds to the tune of ₹ 6,00,000.
To finance the expansion, the management has following plans:
Plan I Issue of 60,000 Equity shares of ₹ 10 each.

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Plan II Issue of 40,000 Equity shares of ₹ 10, and the balance through long term borrowing at 12% interest p.a.
Plan III Issue of 30,000 Equity shares of ₹ 10 each and 3,000 ₹ 100 9% Debentures.
Plan IV Issue of 30,000 Equity shares of ₹ 10 each and balance through 6% preference shares.
The Company’s EBIT is expected to be ₹ 4,00,000 p.a. Assume Corporate tax rate of 40%. Required:
1. Calculate EPS in each of the above plan.
2. Ascertain the degree of financial leverage in each plan.

Question 5 - Nov 02
A Company earns a profit of ₹ 3,00,000 per annum after meeting its interest liability of ₹ 1,20,000 on 12%
debentures. The tax rate is 50%. The number of Equity Shares of ₹ 10 each are 80,000 and the retained
earnings amount to ₹ 12,00,000. The company proposes to take up an expansion scheme for which a sum of ₹
4,00,000 is required. It is anticipated that after expansion, the company will be able to achieve the same return
on investment as at present. The funds required for expansion can be raised either through debt at the rate of
12% or by issuing Equity Shares at par. Required:
(i) Compute the Earnings Per Share (EPS), if:
● The additional funds were raised as debt.
● The additional funds were raised by issue of equity shares.
(ii) Advise the company as to which source of finance is preferable.

Question 6 - Study Material

The following figures are made available to you:
Net profits for the year 18,00,000
Less: Interest on secured debentures at 15% p.a.
(Debentures were issued 3 months after the (1,12,500 )
commencement of the year)
Profit before tax 16,87,500
Less: Income-tax at 35% and dividend (8,43,750)
distribution tax
Profit after tax 8,43,750
Number of equity shares (₹ 10 each) 1,00,000
Market quotation of equity share ₹ 109.70

The company has accumulated revenue reserves of ₹ 12 lakhs. The company is examining a project calling for
an investment obligation of ₹ 10 lakhs. This investment is expected to earn the same rate as funds already
employed.
You are informed that a debt equity ratio (Debt divided by debt plus equity) higher than 40% will cause the price
earnings ratio to come down by 25% and the interest rate on additional borrowings will cost company 300
basis points more than on their current borrowings in secured. You are required to advise the company on the
probable price of the equity share, if
a) The additional investment were to be raised by way of loans; or
b) The additional investments were to be raised by way of equity shares issued at ₹ 100 per share.

Financial Break-even point & Indifference Point

Question 7 - Study Material, May 11, Mtp, Rtp-Nov 2019(similar)
The management of Z Ltd wants to raise its funds from market to meet out the financial demands of its long
term projects. The Company has various combinations of proposals to raise its funds. You are given the
following proposals of the company:
Proposals % of Equity % of Debt % of Preference
Shares
P 100 - -
Q 50 50 -
R 50 - 50

● Cost of Debt – 10%, Cost of Preference shares – 10%.

● Tax Rate – 50%.
● Equity Shares of the face value of ₹ 10 each will be issued at a premium of ₹ 10 per shares.
● Total Investment to be raised ₹ 40,00,000.

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 Chapter 3 - Capital Structure

● Expected Earnings Before Interest and Tax ₹ 18,00,000.

From the above proposals the management wants to take advice from you for appropriate plan after
computing the following – (1) Earnings Per Share, (2) Financial Break Even Point, and (3) Compute the EBIT
Range among the plans for indifference. Also indicate if any of the plans dominate.

Question 8 - May 03
Calculate the level of EBIT at which EPS Indifference Point between the following financing alternatives will
occur:
● Equity Share capital of ₹ 6,00,000 and 12% Debentures of ₹ 4,00,000 [or]
● Equity Share capital of ₹ 4,00,000, 14% Preference Share Capital of ₹ 2,00,000 and 12% Debentures of ₹
4,00,000.
Assume that corporate Tax Rate is 35% and par value of Equity Share is ₹ 10 in each case.

Question 9 -
A Company has the choice of raising an additional sum of ₹ 25,00,000 either (i) by issue of 8% debentures, or
(ii) issue of additional equity shares @ ₹ 10 per share. Presently, the capital structure of the firm does not
consist of any debt and the company has issued 5,00,000 equity shares only.
1. At what level of EBIT, after the new capital funds are acquired, would the EPS be the same under
different alternative financing plans.
2. Also determine the level of EBIT at which uncommitted earnings per share (UEPS) would be the same,
if the sinking fund obligations amounting to ₹ 2,50,000 in respect of debenture issue is to be made
every year. Tax rate May be assumed at 50% and also verify the result.

Indifference Point – Alternative Financing Approaches

Question 10 - Rtp, Study Material
Ganesha Limited is setting up a project with a capital outlay of ₹ 60,00,000. It has two alternatives in financing
the project cost.
Alternative (a): 100% equity finance in ₹ 200 shares.
Alternative (b): Debt-equity ratio 2:1
The rate of interest payable on the debts is 18% p.a. The corporate tax rate is 40%. Calculate the indifference
point between the two alternative methods of financing.

Question 11 - Study Material

Toyo Limited presently has ₹ 36,00,000 in debt outstanding bearing an interest rate of 10 per cent. It wishes to
finance a ₹ 40,00,000 expansion programme and is considering three alternatives: additional debt at 12 per
cent interest, preferred stock with an 11 per cent dividend, and the sale of common stock at ₹ 16 per share.
The company presently has 8,00,000 shares of common stock outstanding and is in a 40 per cent tax bracket.
a) If earnings before interest and taxes are presently ₹ 15,00,000, what would be earnings per share for the
three alternatives, assuming no immediate increase in profitability?
b) Develop an indifference chart for these alternatives. What are the approximate indifference points? To
check one of these points, what is the indifference point mathematically between debt and common
stock?
c) Which alternative do you prefer? How much would EBIT need to increase before the next alternative would
be best?

Theories of Capital structure

Net Income Approach
Question 12 - Study Material
Rupa Company’s EBIT is ₹ 5,00,000. The company has 10%, 20 lakhs 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 -
Bajaj Ltd. has earnings before interest and taxes (EBIT) of ₹ 20 million. The company currently has outstanding
debt of ₹ 40 million at a cost of 8%.
(a) Using the net income (NI) approach and a cost of equity of 17.5%;

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(1) Compute the total value of the firm and firm’s overall weighted average cost of capital (Ko) and
(2) Determine the firm’s market debt/equity ratio.
(b) Assume that the firm issues an additional ₹ 20 million in debt and uses the proceeds to retire stock; the
interest rate and the cost of equity remain the same.
(1) Compute the new total value of firm and the firm’s overall cost of capital and
(2) Determine the firm’s market debt/equity ratio.

Net Operating Income Approach

Question 14 - Study Material
Amita Ltd’s operating income is ₹ 5,00,000. The firm’s 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 determine:
(i) Total value of the firm;
(ii) Cost of equity.

Question 15 -
Financial Ltd. has EBIT ₹ 20 million. The company currently has outstanding debt of ₹ 40 million at cost of 8%
(a) Using the net operating income approach and an overall cost of capital of 12%;
(1) compute the value of stock market value of firm, and the cost of equity and
(2) determine the firm’s market debt/equity ratio.
(b) Determine the answer to (a) if the company were to sell the additional ₹ 20 million in debt.

Traditional Approach of Capital Structure

Question 16 - Nov 15
Equity shares are issued by Nature Ltd. with equity capitalization rate of 16% to fulfill its whole fund
requirement of ₹ 20,00,000. The company is planning to redeem a part of capital by raising of debt. It has two
alternatives to do so:
Alternative 1 : Raise debt to the limit of 30% of total funds. The rate of interest will be 10% and Ke to rise to
17%.
Alternative 2 : Raise debt to the limit of 50% of total funds. The rate of interest will be 12% and Ke will be 20%.
The operating profit (EBIT) would be ₹ 3,00,000. Using Traditional approach, Compute:
(1) Value of company; (2) Overall cost of capital.

MM Approach & Arbitrage Process

Question 17 - Mtp April 2021
Kee Ltd. and Lee Ltd. are identical in every respect except for capital structure. Kee Ltd. does not employ debt
in its capital structure, whereas Lee Ltd. employs 12% debentures amounting to ₹ 20 lakhs. Assuming that:
(i)All assumptions of MM model are met;
(ii)The income tax rate is 30%;
(iii)EBIT is ₹ 5,00,000 and
(iv)The equity capitalization rate of Kee Ltd. is 25%. CALCULATE the average value of both the Companies.
Calculate the average value of both the companies.

Question 18 - Study Material

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 19 - Study Material

One-third of the total market value of Sanghmani Limited consists of loan stock, which has a cost of 10 per
cent. Another company, Samsui Limited, is identical in every respect to Sanghmani Limited, except that its
capital structure is all-equity, and its cost of equity is 16 per cent. According to Modigliani and Miller, if we
ignored taxation and tax relief on debt capital, COMPUTE the cost of equity of Sanghmani Limited?

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Question 20. - Study Material

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 21 - Rtp- May 2018,Nov 14

Companies Uma and Lata are identical in every respects in every respect except that the former does not use
Debt in its capital structure, while the latter employs ₹ 6 lakhs of 15% Debt. Assume that –
(a) All the M & M assumption are met,
(b) the corporate tax rate is 35%,
(c) the EBIT is ₹ 2,00,000 and
(d) the equity capitalization of the Unlevered Company is 20%.
1. What will be the value of the Firms – Uma and Lata?
2. Determine the weighted Average Cost of Capital for both the firms.

Miscellaneous Practical Problems

Question 22 - Rtp
ABC Ltd adopts Constant-WACC Approach, and believes that its cost of debt and overall cost of capital is at
9% and 12% respectively. If the ratio of the market value Debt to market value of Equity is 0.8, what Rate of
Return do equity shareholders earn? Assume that there are no taxes.

Question 23 - Rtp-Nov 2018(similar), May 12

RES Ltd. is an all equity financed company with a market value of 25,00,000 and cost of equity Ke = 21%. The
company wants to buyback equity share worth 5,00,000 by issuing and raising 15% perpetual debt of the same
amount. Rate of tax May be taken as 30%. After the capital restructuring and applying MM Model (with taxed),
you are required to calculate:
(i) Market value of RES Ltd.
(ii) Cost of Equity Ke
(iii) Weighted average cost of capital and comment on it.

Question 24 - Nov 2022

The following are the costs and values for the firms A and B according to the traditional approach.
Firm A Firm B
Total value of firm, V (in ₹) 50,000 60,000
Market value of debt, D (in ₹) 0 30,000
Market value of equity, E (in ₹) 50,000 30,000
Expected net operating income (in ₹) 5,000 5,000
Cost of debt (in ₹) 0 1,800
Net Income (in ₹) 5,000 3,200
Cost of equity, Ke = NI/V 10.00% 10.70%
1. Compute the Equilibrium value for Firm A and B in accordance with the M-M approach.
Assume that (a) taxes do not exist and (b) the equilibrium value of Ke is 9.09%.
2. Compute Value of Equity and Cost of Equity for both the firms.

Question 25 - Rtp Nov 2022

ABC Limited provides you the following information:
(₹)
Profit (EBIT) 2,80,000
Less: Intt. on Debt @10% 40,000
EBT 2,40,000
Less: Income Tax @ 50% 1,20,000
1,20,000
No. of Equity Shares (₹ 10 each) 30,000

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 Chapter 3 - Capital Structure

Earnings per share (EPS) 4

Price / EPS (P/E) Ratio 10
Ruling Market price per share 40
The company has undistributed reserves of ₹ 7,00,000 and needs ₹ 4,00,000 further for expansion. This
investment is expected to earn the same rate as funds already invested. You are informed that a debt equity
(debt/ debt +equity) ratio higher than 32% will push the P/E ratio down to 8 and raise the interest rate on
additional borrowings (debentures) to 12%. You are required to ASCERTAIN the probable price of the share.
1. If the additional funds are raised as debt; and
2. If the amount is raised by issuing equity shares at ruling market price of ₹ 40 per share.

Question 26 - Rtp May 2023

Current Capital Structure of XYZ Ltd is as follows:
Equity Share Capital of 7 lakh shares of face value ₹ 20 each Reserves of ₹ 10,00,000
9% bonds of ₹ 3,00,00,000
11% preference capital: 3,00,000 shares of face value ₹ 50 each Additional Funds required for XYZ Ltd are ₹
5,00,00,000.
XYZ Ltd is evaluating the following alternatives:
1. Proposed alternative I: Raise the funds via 25% equity capital and 75% debt at 10%. PE ratio in such
scenario would be 12.
2. Proposed alternative II: Raise the funds via 50% equity capital and rest from 12% Preference capital
.PE ratio in such scenario would be 11.
Any new equity capital would be issued at a face value of ₹ 20 each. Any new preferential capital would be
issued at a face value of ₹ 20 each. Tax rate is 34%
Determine the indifference point under both the alternatives.

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