5 Capital Structure

CHAPTER

THEORY

Meaning of Capital Capital structure refers to the mix of a firm’s capitalization i.e. mix of long
Structure term sources of funds such as debentures, preference share capital, equity
share capital and retained earnings for meeting total capital requirement.

Major Factors in (a) Risk (b) Cost of capital

Capital Structure (c) Control (d) Purpose of financing
Planning (e) Flexibility (f) Requirement of investors
(g) Financial leverage or trading on equity (h) Growth and stability of sales

Capital Structure ‰ Capital structure refers to the combination of debt and equity which a
vs Financial company uses to finance its long-term operations.
Structure ‰ Financial Structure is the entire left-hand side of the balance sheet which
represents all the long-term and short-term sources of capital.
‰ Thus, capital structure is only a part of financial structure.

Optimum Capital ‰ It deals with the issue of right mix of debt and equity in the long-term
Structure capital structure of a firm.
‰ The mix should be designed so as to ensure maximization of wealth
which is in line with ob ective of financial management.
‰ In other words, mix should be designed in such a manner which can
provide the highest earnings per share (EPS) over the firm’s expected
range of earnings before interest and tax (EBIT).

‰ Through this analysis, a comparison can be drawn for various methods

of financing by obtaining indifference point.
‰ It is a point to the EBIT level at which EPS remains unchanged irrespective
of debt-equity mix.
‰ The indifference point for the capital mix (equity share capital and debt)
(EBIT − I1 )(1 − t) (EBIT − I2 )(1 − t)
can be determined as follows: =
E1 E2
EBIT-EPS ‰ If amount of equity share capital is same under two financial plans, then
analysis tool or one of the following two situations will arise
Indifference point (a) No indifference point – It will arise when after tax cost of the
analysis
source other than equity shares is not same under both plans.
EPS Plan 2

Plan 1

EBIT
(b) Many indifference point – It will arise when after tax cost of the
source other than equity share is same under both plans.
Plan 1
EPS

Plan 2
Both line
will
coincide

EBIT

Trading on equity ‰ It is the process of using securities with fixed financial burden (e.g. loan,
preference shares, bonds etc.) to produce gain for the owners (equity
shareholders).
‰ It is known as trading on equity because equity shareholders are the
only one interested in the business income and lenders are willing to
advance funds on the strength of the equity supplied by the owners.
‰ Trading on equity occurs if the firm takes debt to acquire assets on which
it can earn return greater than the interest on cost of debt. In this case,
the leverage is favourable for the firm.

General (a) There are only two sources of funds (i) Equity and (ii) Debt having fixed
assumptions of all interest
approaches (b) Total assets of the firm are given and there would be no change in the
decisions of the firm.
(c) There are no retained earnings i.e. dividend payout ratio is 100%.
(d) The operating profit, i.e. EBIT of the firm is given and is not expected to
grow.
(e) Business risk of the firm is given and it does not get affected by the
financing mix.

Capital Structure 115

Net Income (NI) S NI A :
Approach (a) The debt capitalization rate (Kd) is less than the equity capitalization
rate (Ke).
(b) The use of debt component doesn’t change the risk perception of
investors. As a result, both debt capitalization rate (Kd) and equity
capitalization rate (Ke) remains constant.
(c) There are no personal or corporate taxation.
A :
‰ According to this approach, capital structure decision is relevant to the
value of the firm.
‰ With the increase in debt of the firm, the WACC would decline because
of use of relatively less expensive debt and in turn, the value of firm will
increase and vice-versa.
‰ The optimum capital structure will be at a point where WACC is minimum
and value of firm is maximum.
EBIT – Interest
Value of Equity (VE) =
Cos t of Equity
Value of Firm (VF) = Value of Equity (VE) + Value of Debt (VD)
EBIT
Overall cost of capital (KO) =
Value of firm
Cost of Capital

Ke

Ko
Kd

Leverage

Traditional S A T A :
Approach (a) There are no personal or corporate taxes.
(b) The increase in proportion of debt in capital structure leads to change in
risk perception of the shareholders.
(c) The debt capitalization rate (Kd) is less than the equity capitalization
rate (Ke).
A :
‰ It is also known as intermediate approach as it takes a midway between
NI approach and the NOI approach.
‰ According to this approach, with the increase in debt upto a certain
reasonable limit, the overall cost of capital (WACC) will start declining
because of use of relatively cheaper debt funds.

116 Financial Management PW

 ‰ If the debt is increased beyond the reasonable limit, both the cost of
equity (ke) and cost of debt (kd) will start rising due to excess level of
financial risk.
‰ As a result, WACC of the firm starts rising.
‰ The optimum capital structure will be at a point where WACC is minimum
and value of firm is maximum.
EBIT – Interest
Value of Equity (VE) =
Cos t of Equity
Value of Firm (VF) = Value of Equity (VE) + Value of Debt (VD)
EBIT
Overall cost of capital (KO) =
Value of firm
Cost of Capital ke
Ko
Kd

Leverage

Net Operating S N I :
Income (NOI) (a) There are no corporate or personal taxes.
Approach (b) The market capitalizes the value of the firm as whole. Thus the split
between debt and equity is not important.
(c) The increase in proportion of debt in capital structure leads to change in
risk perception of the shareholders.
(d) The overall cost of capital (Ko) remains constant for all degrees of debt
equity mix.
A :
‰ According to this approach, WACC of the firm or value of firm is
independent of its capital structure.
‰ With the increase in the debt component in the capital structure, the
financial risk of equity shareholders increases.
‰ To compensate the increased risk the shareholders would expect a
higher rate of return on their investments.
‰ Thus, the benefit of using relatively cheaper debt funds is offset by the
loss arising out of the increase in cost of equity.
‰ As a result, the overall cost (value of firm) remains constant irrespective
of capital structure.
EBIT
Value of Firm (VF) =
Overall cost of capital
Value of Equity (VE) = Value of Firm (VF) - Value of Debt (VD)

Capital Structure 117

 EBIT - Interest
Cost of Equity (KE) =
Valueof equity
Ke

Cost of capital
Ko

Kd

Leverage
Modigilani and S MM A :
Miller (MM) (a) Capital markets are perfect and investors are assumed to be rational.
Approach (b) There are no personal or corporate taxes.
(c) Firms can be categorized into equivalent return classes. All firms
within a class have the same degree of business risk.
(d) All investors have the same expectations from a firm’s net operating
income (EBIT) which are necessary to evaluate the value of a firm.
T :
1. The total market value of the firm and its cost of capital are independent
of its capital structure. The total market value of a firm is given by
capitalizing the expected stream of operating earnings at a discount rate
appropriate for its risk class.
2. The cost of equity (Ke) is equal to capitalization rate of pure equity
stream plus a premium for financial risk. The financial risk increases
with more debt content in the capital structure. As a result, Ke increases
in a manner to offset exactly the use of less expensive source of funds.
3. The cut-off rate for investment purposes is completely independent of
the way in which an investment is financed. This proposition along-with
the first implies a complete separation of the investment and financing
decisions of the firm.
Value of levered firm (VL) = Value of unlevered firm (VU)
EBIT
=
OverallCost of Capital
D
KeL = KeU + (KeU– kd) ×  
E
Ke
Cost of capital

Ko
Kd

Leverage

118 Financial Management PW

MM Approach with ‰ MM recognized that the value of the firm will increase and the cost of
corporate taxes capital will decrease with the use of debt on account of deductibility of
interest charges for tax purpose.
‰ Thus, the optimum capital structure can be achieved by maximizing the
debt mix in the equity of the firm.
EBIT(1 − t)
Value of unlevered firm (VU) =
Overall cost of capital
Value of levered firm (VL) = Value of unlevered firm (VU) + (Debt)(tax rate)
D
KeL = KeU + (KeU – kd) × (1 – t) ×  
E

Weakness of MM (a) Since, the interest on debt is tax deductible, a levered firm is in position
hypothesis to take the advantage of trading on equity. Hence, the total market value
of a levered firm is likely to exceed that of unlevered firm.
(b) Other hidden costs associated with leverage, such as bankruptcy and
agency costs have not been considered.
(c) Investors may not substitute personal leverage for corporate leverage
since they don’t have the same risk characteristic.
(d) The assumption that an individual will be able to borrow at the same
rate at which corporations are able to issue debentures at any point of
time is not realistic.
(e) Institutional restrictions may not permit institutional investors to
engage in home made leverage.
Arbitrage process ‰ Arbitrage is the process of purchasing a security in a market where the
price is low and selling it in a market where the price is higher.
‰ A A P :
When Levered Firm is overvalued When Unlevered Firm is
overvalued
1) Investor sells his present equity 1) Investor sells his present equity
holdings of levered firm. holdings of unlevered firm.
2) Investor borrows proportionate 2) Investor purchases securities
to his share of debt of levered of the levered firm equal to his
firm (because personal leverage percentage equity holdings in the
is perfect substitute of corporate unlevered firm.
leverage).
3) Investor purchases securities of 3) Investor will also invest
the unlevered firm equal to his proportionately in the debt
percentage equity holdings in the instruments.
levered firm.
4) After one year, investor will 4) After one year, investor will
receive dividend and will pay receive dividend and interest
interest on personal debt taken. from his investment.

Capital Structure 119

 5) Thus, investor will earn higher 5) Thus, investor will earn higher
rate of return in unlevered firm rate of return in levered firm
as compared to continuing in as compared to continuing in
levered firm. unlevered firm.
‰ According to MM, this arbitrage process will come to an end when the
values of both companies become identical.
The Trade-off ‰ This theory helps to find the optimum level of debt by balancing the cost
Theory and benefits.
‰ Benefits of using debt is tax saving on interest
‰ Cost of using debt involves financial distress and agency cost
‰ In case if company is not able to meet the payment obligations to the
debt holder than it may become insolvent which leads to various cost
such as legal cost, admin. Cost , bankruptcy cost etc.
‰ Also, there might be dispute between shareholders, management &
debt-holders which gives rise to agency cost.
‰ The marginal benefit of further increase in debt declines as debt
increases.
‰ Thus, firm tries to trade-off the cost with benefit to optimize or maximize
the overall value.
Maximum
Value fo firm

Costs of Financial
PV of interest
tax shields distress

Value of
Unlevered
Firm Debt
Optimal debt level Level

Pecking Order ‰ This theory states that capital structure decision is affected by manager’s
Theory choice.
‰ Thee is no well-defined equity-debt mix.
‰ There are two sources i.e. internal & external
‰ Debt is the most cheaper source
‰ Internal equity is cheaper than external equity because it doesn’t involve
transaction or issue cost etc.
‰ As per this theory, manager may raise funds from various sources in
following order
 First choice is to use internal finance
 In absence or shortage of internal finance then use secured debt,
unsecured debt etc.
 Manager may issue new equity shares as last option.

120 Financial Management PW

Over It is a situation where a firm has more capital than it needs or in other words
Capitalization assets are worth less than its issued share capital, and earnings are insufficient
to pay dividend and interest.
Causes of over (a) Raising more money through issue of equity shares or debentures than
capitalization company can employ profitably.
(b) Borrowing huge amount at higher rate than rate at which company can
earn.
(c) Excessive payment for the acquisition of fictitious assets such as goodwill
etc.
(d) Wrong estimation to earnings and capitalization.
Consequences of (a) Considerable reduction in the rate of dividend and interest payments.
over capitalization (b) Reduction in the market price of shares
(c) Resorting to window dressing
(d) Some companies may opt for reorganization
Remedies of over (a) Companies should go for thorough reorganization
capitalization (b) Buyback of shares
(c) Reduction in claims of debenture-holders and creditors
(d) Value of share may also be reduced.
Under ‰ It is a state, when company’s actual capitalization is lower than its proper
Capitalization capitalization as warranted by its earning capacity.
‰ This situation normally happens with companies which have insufficient
capital but large secret reserves in the form of considerable appreciation
in the values of fixed assets not brought into the books.
Consequences (a) The dividend rate will be higher in comparison to similarly situated
of under companies.
capitalization
(b) Market value of shares will be higher than value of shares of other similar
companies.
(c) Real value of shares will be higher than their book values.
Remedies of under (a) The shares of the company should be split up.
capitalization (b) Issue of bonus shares.
(c) By revising upward the par value of share in exchange of the existing
shares.
Over capitalization ‰ Over capitalization is more dangerous to the company, society and
vs under shareholders than under capitalization.
capitalization
‰ Situation of under capitalization can be handled easily as compared to
over capitalization.

Capital Structure 121

 PRACTICAL QUESTIONS
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.
[Sol. EPS - `15 `18.33 `21 `17.33]
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 ob ective of maximizing earnings per share.
It has three alternatives to finance the pro ect – 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 [SM]
[Sol. EPS - `15.83 `18.125 `16.406]
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 pro ect 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.
(c) To issue equity capital for `25 lakhs (face value of `10 each) and 16% non-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% [SM]

[Sol. EPS - `4.17 `4.60 `4.57]

122 Financial Management PW

 4. The following data are presented in respect of SK Ltd. [SM]
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 pro ect requiring a total capital outlay of `40,00,000. ou
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).
[Sol. (a) `20.66 `24.44]
5. The financial advisor of SK Ltd. is confronted with following two alternative financing plans for
raising `10 lakhs that is needed for plant expansion and modernization.
Alternative I – Issue 80% of funds with 14% Debenture (Face value `100) at par and redeem at
a premium of 10% after 10 years and balance by issuing equity shares at 33(1/3)% premium.
Alternative II – Raise 10% of funds required by issuing 8% irredeemable debentures (face value
`100) at par and the remaining by issuing equity shares at current market price of `125.
Currently, the firm has an Earnings per share (EPS) of `21.
The modernization and expansion programme is expected to increase the firm’s Earnings before
Interest and Taxation (EBIT) by `2,00,000 annually.
The firm’s condensed Balance Sheet for the current year is as given below
Balance Sheet as on 31.3.2022
Liabilities (`) Assets (`)
Current Liabilities 5,00,000 Current Assets 16,00,000
10% Long term loan 15,50,000 Plant & Equipment (Net) 34,00,000
Reserve & Surplus 10,00,000
Equity share capital 20,00,000
(FV: `100 each)
50,00,000 50,00,000
However, the finance advisor is concerned about the effect that issuing of debt might have on the
firm. The average debt ratio for firms in industry is 35%. He believes if this ratio is exceeded, the
PE ratio of the company will be 7 because of the potentially greater risk.
If the firm increases its equity capital by more than 10%, he expects the PE ratio of the company
will increase to 8.5 irrespective of the debt ratio.
Capital Structure 123
 Assume tax rate of 25%. Assume target dividend pay-out under each alternative to be 60% for
the next year and growth rate to be 10% for the purpose of calculating cost of equity.
Suggest with reasons which alternative is better on the basis of each of the below given criteria
(a) Earnings per share (EPS) & Market Price per share (MPS)
(b) Financial Leverage
(c) Weighted Average Cost of Capital & Marginal Cost of Capital (using Book Value Weights)
[Sol. (a) EPS – `22.60 `20.74 MPS - `158.20 `176.29 (b) 1.40 1.21 (c) WACC – 9.12% 7.66%
MACC – 10.65% 7.58%]
6. SK Limited requires funds amounting to `80 lakhs for its new pro ect. 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.
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. [SM]
[Sol. `9,60,000]
7. SK Ltd. is considering three financing plans. The key information is as follows
(a) Total investment to be raised `2,00,000 [SM, Similar Nov 2020]
(b) Plans of financing portion
Plans Equity Debt Preference
A 100% – –
B 50% 50% –
C 50% – 50%
(c) Cost of debt 8%
(d) Cost of preference shares 8%
(e) Tax rate 50%
(f) Equity share of the face value of `10 each will be issued at a premium of `10 per share
(e) Expected EBIT is `80,000.
ou 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.
[Sol. (i) `4 `7.20 `6.40 (ii) Nil `8,000 `16,000 (iii) Plan B]
8. SK Ltd.’s EBIT is `5,00,000. The company has 10%, `20 lakh debentures. The equity capitalization
rate i.e. ke is 16%.
ou are required to calculate
(i) Market value of equity and value of firm
(ii) Overall cost of capital
(iii) If company decides to redeem `3,00,000 equity with 10% debt, compute value of equity and
overall cost of capital. [SM]
[Sol. (i) `38,75,000 (ii) 12.90% (iii) `16,87,500 12.54%]
124 Financial Management PW
 9. 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 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%. ou are required to compute value
of firm and its overall cost of capital under different options if the traditional approach
is held valid.
[Sol. Ko = 16% 14.91% 15.79%]
10. 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.
[Sol. (a) `40,00,000 `40,00,000 10% (b) `40,00,000 `30,00,000 10.33% `15,500]
11. 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. [SM, Similar Jan 2021]
(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.
[Sol. (a) (i) `5,600 (ii) 28% (b) (i) 20.50%]
12. 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 [SM, Similar RTP May 2021]
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
Capital Structure 125
 (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
[Sol. (a) 10% 9.85% 9.60% 9.47% 9.44% 9.50% 10% (b) 10% 10.67% 11.50% 12.36% 13.33%
14.50% 16%]
13. 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
[Sol. `130.40]
14. 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.
[Sol. `323]
15. 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 `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.
[Sol. Chunnu = `5,00,000 20% Munnu = `8,00,000 12.50%]
16. 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
R :
(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.
[SM, Similar July 2021, Nov 2018]
[Sol. (a) Vf = `1,00,00,000 Ko = 18% (b) Vb = `60,00,000 Va = `81,60,000 Ko-B = 18% Ko-A = 13.23%]
17. 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 [SM, Similar May 2018]
[Sol. (a) MV increase by `82,50,000 (b) Ko decrease by 0.90% (c) Ke increase by 0.62%]

126 Financial Management PW

 18. Company P and Q are identical in all respects including risk factors except for debt/equity, company
P having issued 10% debentures of `18 lakhs while company Q is unlevered. Both the companies
earn 20% before interest and taxes on their total assets of `30 lakhs.
Assuming a tax rate of 50% and capitalization rate of 15% from an all-equity company.
Required
CALCULATE the value of companies P and Q using (a) Net Income Approach and (b) net Operating
Income Approach. [RPT May 2018]
[Sol. (a) `32,00,000 `20,00,000 (b) `20,00,000 `29,00,000]

PRACTICE QUESTIONS
19. 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 earnings per share under the
three financing alternatives.
[Sol. EPS - `1.25 `1.46 `1.36 ]
20. Y Limited requires `50,00,000 for a new plant. This Plant is expected to yield earnings before
interest and taxes of `10,00,000. While deciding about the financial plan, the company considers
the ob ective of maximizing earnings per share. It has two alternatives to finance the pro ect – by
raising debt of `5,00,000 or `20,00,000 and the balance in each case by issuing equity shares.
The company’s share is currently selling at `300 but is expected to decline to `250 in case the
funds are borrowed in excess of `20,00,000. The funds can be borrowed at the rate of 12% upto
`5,00,000, at 10% over `5,00,000. The tax rate applicable to the company is 25%. Which form of
financing should company choose [Nov 2018]
[Sol. `47 `59.25]
21. RM Steels Limited requires `10,00,000 for construction of a new plant. It is considering three
financial plans [May 2019]
(i) The company may issue 1,00,000 ordinary shares at `10 per share
(ii) The company may issue 50,000 ordinary shares at `10 per share and 5,000 debentures of
`100 denominations bearing at 8% rate of interest and
(iii) The company may issue 50,000 ordinary shares at `10 per share and 5,000 preference shares
at `100 per share bearing a 8% rate of dividend.
If RM Steels Limited’s earnings before interest and taxes are `20,000 `40,000 `80,000 `1,20,000
and `2,00,000, you are required to compute the earnings per share under each of the three financial
plans Which alternative would you recommend for RM Steels and why Tax rate is 50%.
[Sol. Plan (i) - `0.10 `0.20 `0.40 `0.60 `1 Plan (ii) - `(0.20) Nil `0.40 `0.80 `1.60
Plan (iii) - `(0.60) `(0.40) Nil `0.40 `1.20]

Capital Structure 127

 22. 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 fund of `6,00,000. It is anticipated 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 shares at par. Tax rate is 40%.
Required to 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. [Dec 2021]
[Sol. EPS - `2.610 `1.800]
23. The particulars relating to Ra Ltd. for the year ended 31st March, 2022 are given as follows
Output (units at normal capacity) 1,00,000
Selling price per unit `40
Variable cost per unit `20
Fixed cost `10,00,000
The capital structure of a company as on 31st March, 2022 is as follows
Particulars Amount in `
Equity share capital (1,00,000 shares of `10 each) 10,00,000
Reserve and surplus 5,00,000
Current liabilities 5,00,000
Total: 20,00,000
Ra Ltd. has decided to undertake an expansion pro ect to use the market potential that will
involve `20 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 15%. The additional output can be
sold at existing selling price without any adverse impact on the market. [May 2022]
The following alternative schemes for financing the proposed expansion program are planned
(Amount in `)
Alternative Debt Equity Shares
1 5,00,000 Balance
2 10,00,000 Balance
3 14,00,000 Balance
Current market price per share is `200.
Slab wise interest rate for fund borrowed is as follows
Fund Limit Applicable interest rate
Up-to `5,00,000 10%
Over `5,00,000 and up-to `10,00,000 15%
Over `10,00,000 20%

128 Financial Management PW

 Find out which of the above-mentioned alternatives would you recommend for Ra Ltd. with
reference to the EPS, assuming a corporate tax rate is 40%
[Sol. `10.60 `10.43 9.87]
24. The following information pertains to CI A Ltd. [May 2023]
C S : `d
Capital Structure
Equity share capital (`10 each) 8,00,000
Retained earnings 20,00,000
9% Preference share capital (`100 each) 12,00,000
12% Long-term loan 10,00,000
Interest coverage ratio 8
Income tax rate 30%
Price – earnings ratio 25
The company is proposed to take up an expansion plan, which requires an additional investment
of 34,50,000. Due to this proposed expansion, earnings before interest and taxes of the company
will increase by 6,15,000 per annum. The additional fund can be raised in following manner
 By issue of equity shares at present market price, or
 By borrowing 16% Long-term loans from bank.
ou are informed that Debt-equity ratio (Debt/ Shareholders’ fund) in the range of 50% to 80%
will bring down the price-earnings ratio to 22 whereas Debt-equity ratio over 80% will bring
down the price-earnings ratio to 18.
Required
Advise which option is most suitable to raise additional capital so that the Market Price per Share
(MPS) is maximized.
[Sol. MPS – `221 `117.90]
25. CALCULATE the level of earnings before interest and tax (EBIT) at which the EPS indifference
point between the following financing alternatives will occur. [RTP May 2020]
(i) Equity share capital of `60,00,000 and 12% debentures of `40,00,000.
(ii) Equity share capital of `40,00,000, 14% preference share capital of `20,00,000 and 12%
debentures of `40,00,000.
Assume the corporate tax rate is 35% and par value of equity share is `100 in each case.
[Sol. `17,72,308]
26. SK Ltd. is setting up a pro ect with a capital outlay of `60,00,000. It has two alternatives in financing
the pro ect cost.
Alternative – I 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.
[Sol. `10,80,000]
Capital Structure 129
 27. SK Ltd. is considering a new pro ect 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 pro ect
considering the Debt Equity ratio insisted by the financing agencies being 2 1.
[Sol. `1,08,00,000]
28. Sun Ltd. is considering two financing plans Details of which are as under [May 2018]
(i) Fund’s requirement – `100 lakhs
(ii) Financial Plan
Plan Equity Debt
I 100% -
II 25% 75%
(iii) Cost of debt – 12% p.a.
(iv) Tax rate – 30%
(v) Equity share of `10 each, issued at a premium of `15 per share
(vi) Expected earnings before interest and taxes (EBIT) `40 lakhs
ou are required to compute
(a) EPS in each of the two plans
(b) The financial break-even point
(c) Indifference point between Plan I and Plan II
[Sol. (a) `7 `21.70 (b) `0 `9,00,000 (c) `12,00,000]
29. Current Capital Structure of 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 Ltd are `5,00,00,000.
Ltd is evaluating the following alternatives [RTP May 2023]
(I) Proposed alternative I Raise the funds via 25% equity capital and 75% debt at 10%. PE Ratio
in such scenario would be 12.
(II) 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.
[Sol. Indifference point = `72,63,636.36]

30. 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

130 Financial Management PW

 Particulars Plan – A (`) Plan – B (`)
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.
[Sol. 8.40%]
31. 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.
[Sol. (a) `0.495 `0.305 `0.651 (b) `23,76,000 ]
32. 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%.
ou are required to calculate
(a) Current value of the firm
(b) Overall cost of capital
(c) Find value of firm and overall cost of capital if firm increases debt by `2,00,000
[ Sol. (a) `8,33,333 (b) 12% (c) `9,00,000 11.11%]
33. 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.
[Sol. `375]
34. 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%

Capital Structure 131

 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.
[Sol. `900 ]
35. Determine the optimal capital structure of a company from the following information
Options Cost of Debt (Kd) in Cost of Equity (Ke) Percentage of Debt on total
% 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
[Sol. 13% 12.80% 13.52% 14.10% 14.80% 16.50% 18.80%]
36. 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%. ou are required
to calculate:
(a) Total value of the firm (b) Cost of Equity
[Sol. (a) `33,33,333 (b) 19.09%
37. SK Ltd. has a net operating income of `21,60,000 and the total capitalization of `120 lakhs. The
company is evaluating the options to introduce debt financing in the capital structure and the
following information is available at various levels of debt value.
Debt Value (`) Interest rate (%) Equity Capitalization rate (%)
0 NA 12.00
10,00,000 7.00 12.50
20,00,000 7.00 13.00
30,00,000 7.50 13.50
40,00,000 7.50 14.00
50,00,000 8.00 15.00
60,00,000 8.50 16.00
70,00,000 9.00 17.00
80,00,000 10.00 20.00
ou are required to compute the equity capitalization rate if MM approach is followed. Assume
that the firm operates in zero tax regime and calculations to be based on book values.
[Sol. 18% 19% 20.20% 21.50% 23.25% 25.14% 27.50% 30.60% 34%]
38. 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.
[Sol. 19% ]
132 Financial Management PW
 39. The following are the costs and value for the firms A and B according to the traditional approach.
Particulars 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/E 10.00% 10.70%
(a) Compute the Equilibrium value for the firm A and B in accordance with the MM approach.
Assume that (i) taxes do not exist and (ii) the equilibrium value of Ke is 9.09%.
(b) Compute value of equity and cost of equity for both the firms. [Nov 2022]
[ Sol. (a) `55,005.50 `55,005.50 (b) `55,005.50 9.09% `25,005.50 12.80%]
40. Rounak 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 shares 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 taxes), you are required to COMPUTE
(a) Market value of the company [RTP Nov 2018]
(b) Cost of equity
(c) Weighted average cost of capital (using market weights) and comment on it.
[Sol. (a) `26,50,000 (b) 21.98% (c) 19.80%]
41. 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 pro ect 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.

Capital Structure 133

 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%.
[Sol. EPS - `5.19 `6.80 `10.20 DCL – 1.91 1.94 1.98]
42. Kalyanam Ltd. has an operating profit of `34,50,000 and has employed Debt which gives total
Interest Charge of `7,50,000. The firm has an existing cost of equity and cost of debt as 16% and
8% respectively. The firm has a new proposal before it, which requires funds of `75 lakhs and is
expected to bring an additional profit of `14,25,000. To finance the proposal, the firm is expecting
to issue an additional debt at 8% and will not be issuing any new equity shares in the market.
Assume no tax culture.
ou are required to calculate the Weighted Average Cost of capital (WACC) of Kalyanam Ltd
(a) Before the new proposal (b) After the new proposal
[Sol. (a) 13.15% (b) 14.45%]

SOLUTIONS
19. EPS :

Particulars Equity Debt Preference

Financing Financing Financing
(`) (`) (`)
EBIT 3,12,500 3,12,500 3,12,500
Less Interest 0 20,000 0
PBT 3,12,500 2,92,500 3,12,500
Less: Taxes 1,56,250 1,46,250 1,56,250
PAT 1,56,250 1,46,250 1,56,250
Less Preference dividend 0 0 20,000
Earnings available to ordinary shareholders 1,56,250 1,46,250 136,250
Shares outstanding 1,25,000 1,00,000 1,00,000
EPS 1.25 1.46 1.36
20.
Particulars Option A Option B
Fund from Equity 45,00,000 30,00,000
Fund from Debt 5,00,000 20,00,000

134 Financial Management PW

 Particulars Option A Option B
EBIT 10,00,000 10,00,000
Less Interest 60,000 2,10,000
[5,00,000×12%] [(5,00,000×12%) +
(15,00,000×10%)]
EBT 9,40,000 7,90,000
Less Tax 25% 2,35,000 1,97,500
EAT/EAE (A) 7,05,000 5,92,500
No. of Equity Shares (B) 15,000 10,000
[45,00,000 300] [30,00,000 300]
EPS (A ÷ B) 47 59.25

Financing Option B i.e. raising debt of `20,00,000 and equity of `30,00,000 is the option which
maximizes the earning per share.
21. Computation of EPS under (i) Plan
Particulars ` ` ` ` `
EBIT 20,000 40,000 80,000 1,20,000 2,00,000
Less Interest – – – – –
EBT 20,000 40,000 80,000 1,20,000 2,00,000
Less Tax 50% 10,000 20,000 40,000 60,000 1,00,000
EAT 10,000 20,000 40,000 60,000 1,00,000
Less Pref. Dividend – – – – –
EAE 10,000 20,000 40,000 60,000 1,00,000
No. of Equity Shares 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000
EPS 0.10 0.20 0.40 0.60 1

Computation of EPS under (ii) Plan

Particulars ` ` ` ` `
EBIT 20,000 40,000 80,000 1,20,000 2,00,000
Less Interest 40,000 40,000 40,000 40,000 40,000
EBT (20,000) – 40,000 80,000 1,60,000
Less Tax 50% 10,000* – 20,000 40,000 80,000
EAT (10,000) – 20,000 40,000 80,000
Less Pref. Dividend – – – – –
EAE (10,000) – 20,000 40,000 80,000
No. of Equity Shares 50,000 50,000 50,000 50,000 50,000
EPS (0.20) – 0.40 0.80 1.60

*Assuming tax saving due to this loss

Capital Structure 135

 Computation of EPS under (iii) Plan
Particulars ` ` ` ` `
EBIT 20,000 40,000 80,000 1,20,000 2,00,000
Less Interest – – – – –
EBT 20,000 40,000 80,000 1,20,000 2,00,000
Less Tax 50% 10,000 20,000 40,000 60,000 1,00,000
EAT 10,000 20,000 40,000 60,000 1,00,000
Less Pref. Dividend 40,000* 40,000 40,000 40,000 40,000
EAE (30,000) (20,000) – 20,000 60,000
No. of Equity Shares 50,000 50,000 50,000 50,000 50,000
EPS (0.60) (0.40) – 0.40 1.20
*Assuming cumulative preference shares so dividend has to be paid to them.
From the above EPS calculation tables under the three financial plans we can see that when EBIT
is `80,000 or more, Plan (ii) i.e. Debt-equity mix is preferable over the other plans as the EPS is
more under it.
On the other hand, EBIT of less than `80,000 or less, Plan (i) i.e. equity financing is preferable
over the other plans as the EPS is more under it.
The final choice of plan will depend on the performance of the company and other macro-economic
conditions.
22. Existing capital employed = Equity + Retained Earnings + Debentures
= (80,000 ×10) + 12,00,000 + (1,20,000 12%) = `30,00,000
Capital employed after expansion = 30,00,000 + 6,00,000 = `36,00,000
Existing EBIT 4,50,000
New EBIT = ×New Capital = ×36,00,000 = `5,40,000
Existing Capital 30,00,000
Statement of EPS
Particulars Existing Additional fund Additional fund
as debt as equity
EBIT 4,50,000 5,40,000 5,40,000
Less Interest
– Existing Debt 1,20,000 1,20,000 1,20,000
– New Debt – 72,000 –
EBT 3,30,000 3,48,000 4,20,000
Less Tax 40% 1,32,000 1,39,200 1,68,000
EAT/EAE (A) 1,98,000 2,08,800 2,52,000
No. of Equity shares (B) 80,000 80,000 1,40,000
EPS (A B) 2.475 2.610 1.800
EPS is higher when the additional funds are raised through debt, thus it is the recommended
option for the company.

136 Financial Management PW

23. Calculation of EBIT
Particulars Existing Proposed
Sale units 1,00,000 1,50,000
Contribution per unit 40 – 20 = 20 40 – (20×85%) = 23
Total contribution 20,00,000 34,50,000
Less Fixed cost 10,00,000 15,00,000
EBIT 10,00,000 19,50,000
Statement of EPS
Particulars Existing Alternative – 1 Alternative – 2 Alternative – 3
EBIT 10,00,000 19,50,000 19,50,000 19,50,000
Less Interest – 50,000 1,25,000 [(5lakh×10%) +
(5,00,000 × [(5lakh×10%) + (5lakh×15%) +
10%) (5lakh×15%)] (4lakh×20%)]
EBT 10,00,000 19,00,000 18,25,000 16,95,000
Less Tax 40% 4,00,000 7,60,000 7,30,000 6,78,000
EAT / EAE (A) 6,00,000 11,40,000 10,95,000 10,17,000
No. of Equity Shares
Existing 1,00,000 1,00,000 1,00,000 1,00,000
New – ÷ 10,00,00 ÷ 200 6,00,000 ÷ 200
= = 5,000 = 3,000
Total Equity Shares (B) 1,07,500 1,05,000 1,03,000
EPS (A B) 6.00 10.60 10.43 9.87
Since, Alternative – 1 has highest EPS, thus it is recommended to raise funds in combination of
debt of `5,00,000 and balance `15,00,000 from equity.
24. :
(a) Interest coverage ratio = 8
EBIT
=8
Interest
EBIT = 8 × 1,20,000 = `9,60,000
(b) Proposed EBIT = 9,60,000 + 6,15,000 = 15,75,000
(c) Option – 1
Debt = `10,00,000
Shareholder’s fund = 8,00,000 + 20,00,000 + 12,00,000 + 34,50,000 = `74,50,000
Debt 10, 00, 000
Debt equity ratio = = = 0.1342 = 13.42%
Shareholder′s fund 74,50, 000
PE Ratio in this case will be 25 times.
(d) Option – 2
Debt = 10,00,000 + 34,50,000 = `44,50,000
Shareholder’s fund = 8,00,000 + 20,00,000 + 12,00,000 = `40,00,000
Capital Structure 137
 Debt 44,50, 000
Debt equity ratio = = = 1.1125 = 111.25%
Shareholder′s fund 40, 00, 000
PE Ratio in this case will remain at 18 times
34,50, 000
New number of equity shares to be issued = = 23,000
150
(e) Calculation of Existing EPS and MPS
Particulars `
Current EBIT 9,60,000
(-) Interest 1,20,000
EBT 8,40,000
(-) Tax 2,52,000
EAT 5,88,000
(-) Preference dividend (12,00,000 × 9%) 1,08,000
Net earnings for equity 4,80,000
Number of equity shares 80,000
EPS 6
PE Ratio 25
MPS 150

C EPS MPS
Particulars Option – 1 Option – 2
Equity shares issued 16% long term debt
EBIT 15,75,000 15,75,000
(-) Interest on 12% debentures 1,20,000 1,20,000
(-) Interest on 16% debt – 5,52,000
EBT 14,55,000 9,03,000
(-) Taxes 30% 4,36,500 2,70,900
EAT 10,18,500 6,32,100
(-) Preference dividend 1,08,000 1,08,000
Net earnings for equity 9,10,500 5,24,100
Number of equity shares 1,03,000 80,000
EPS 8.84 6.55
PE Ratio 25 18
MPS 221 117.90

Equity option has higher market price per share therefore company should raise additional fund
through equity option.

138 Financial Management PW

25. Indifference level between two given plans is given as below:
EPS of (i) = EPS of (ii)
[EBIT − (40,00,000×12%)](1 − 0.35) EBIT − ( 40,00,000 × 12% )  (1 − 0.35) − ( 20,00,000 × 14% )
= =
60,000 40,000
0.65( EBIT ) − 3,12, 000 0.65( EBIT ) − 5,92,000
=
3 2
1.30(EBIT) – 6,24,000 = 1.95(EBIT) – 17,76,000
EBIT = `17,72,308
26. Alternative-I By issue of 6,00,000 equity shares of `10 each amounting to `60 lakhs. No financial
charges are involved.
Alternative-II By raising the funds in the following way
debt = `40 Lakhs Equity = `20 Lakhs (2, 00, 000 equity shares of `10 each) Interest Payable on
18
debt = 40, 00, 000 × =`7,20,000
100
The indifference point between the two alternatives is calculated by
( EBIT − I1 )(1 − T ) = ( EBIT − I2 )(1 − T )
E1 E2
( EBIT − 0)(1 − 0.40) = ( EBIT − 7,20,000)(1 − 0.40)
6,00,000 2,00,000

( EBIT )(0.60) = ( EBIT − 7,20,000)(0.60)

6,00,000 2,00,000
EBIT ( 0.60) 0.60 ( EBIT − 7,20,000)
=
3 1
EBIT = 3(EBIT) – 21,60,000
21,60,000
EBIT = = 10,80,000
2
Therefore, at EBIT of `10,80,000 earnings per share for the two alternatives is equal.
27. The capital investment can be financed in two ways i.e.
(i) By issuing equity shares only worth `9 crore or
(ii) By raising capital through taking a term loan of `6 crores and `3 crores through issuing equity
shares (as the company has to comply with the 2 1 Debt Equity ratio insisted by financing
agencies).
In first option interest will be ero and in second option the interest will be `72, 00, 000
Point of Indifference between the above two alternatives

EBIT × (1 − t ) (EBIT − Interest) × (1 − t)

= =
No. of equity shares(N1 ) No. of equity shares(N2 )

Capital Structure 139

 EBIT (1 – 0.30) ( EBIT – ` 72,00,000) × (1 – 0.30)
Or =
90,00,000 shares 30,00,000 shares
Or 0.7 EBIT = 2 1EBIT – `1, 51, 20, 000
EBIT = `1, 08, 00, 000
EBIT at point of Indifference will be `1.08 crore.
(The face value of the equity shares is assumed as `10 per share. However, indifference point will
be same irrespective of face value per share).
28. (a) Computation of EPS
Particulars Plan I Plan II
EBIT 40,00,000 40,00,000
Less Interest – 9,00,000
(75,00,000×12%)
EBT 40,00,000 31,00,000
Less Tax 30% 12,00,000 9,30,000
EAT/EAE (A) 28,00,000 21,70,000
No. of Equity Shares (B) 4,00,000 1,00,000
[100,00,000 25] [25,00,000 25]
EPS (A ÷ B) 7 21.70
(b) Computation of Financial Break-even Point
Preference Dividend
Plan I = Interest + = 0 + 0 = `0
(1 – t )
Preference Dividend
Plan II = Interest + = 9,00,000 + 0 = `9,00,000
(1–t )
(c) Computation of Indifference Point
( EBIT − Int )(1 − t ) − PD =
( EBIT − Int )(1 − t ) − PD
No. of shares No. of shares
( EBIT − 0)(1 − 0.30) − 0 =
( EBIT − 9,00,000)(1 − 0.30) − 0
4,00,000 1,00,000
(0.70) EBIT (0.70) EBIT − 6,30,000
=
4 1
(0.70)EBIT = (2.80)EBIT – 25,20,000
(0.21)EBIT = 25,20,000
EBIT = `12,00,000
29. Proposed Capital Structure

Capital Proposal I Proposal II

Equity 1,25,00,000 2,50,00,000
(5,00,00,000 × 25%) (5,00,00,000 × 50%)

140 Financial Management PW

 Capital Proposal I Proposal II
Debt 10% 3,75,00,000 –
(5,00,00,000 × 75%)
12% Preference shares – 2,50,00,000
(5,00,00,000 × 50%)

Total Capital Structure (including new proposal)

Capital Proposal I Proposal II

Equity (7,00,000×20) + 1,25,00,000 (7,00,000 × 20) + 2,50,00,000
= 2,65,00,000 = 3,90,00,000
Reserves 10,00,000 10,00,000
9% Bonds 3,00,00,000 3,00,00,000
10% Debt 3,75,00,000 –
11% Preference Shares 1,50,00,000 –
12% Preference Shares – 2,50,00,000
Total 11,00,00,000 11,00,00,000
Let Indifference point be `y.
[y − {(3,00,00,000 × 9% ) + (3,75,00,000 × 10% )} (1 − 0.34 ) − (1,50,00,000 × 11% )
EPS of Proposal I =
7,00,000 + (1,25,00,000 ÷ 20) 
( y − 64,50,000)(0.66 ) − 16,50,000
=
13,25,000
 y − (3,00,00,000 × 9% )  (1 − 0.34 ) − ( 2,50,00,000 × 12% )
EPS of Proposal II = 
[7,00,000 + ( 2,50,00,000 ÷ 20]

=
( y − 27,00,000)(0.66 ) − 46,50,000
19,50,000
For calculation of indifference point,
( y − 64,50,000)(0.66 ) − 16,50,000 ( y − 27,00,000)(0.66 ) − 46,50,000
=
13,25,000 19,50,000
0.66 ( y ) − 42,57,000 − 16,50,000 ( y )(0.66 ) − 17,82,000 − 46,50,000
=
1,325 1,950
0.66 ( y ) − 59,07,000 ( y )(0.66 ) − 64,32,000
=
1,325 1,950
(1,287)y – 11,51,86,50,000 = (874.50)y – 8,52,24,00,000
(412.50)y = 2,99,62,50,000
y = `72,63,636.36
30. Computation of Rate of Preference Dividend

( EBIT – Interest )(1 − t ) = EBIT (1 – t )( – ) Preference Dividend

No. of Equity Shares ( N1 ) No. of Equity Shares ( N2 )
Capital Structure 141
 ( ` 4,80,000– ` 48,000) × (1 – 0.30) = ` 4,80,000(1 – 0.30) – Preference Dividend
80,000 shares 80,000 shares
`3,02,400 `3,36,000 – Preference Dividend
=
80,000 shares 80,000 shares
`3, 02, 400 = EBIT `3, 36, 000 – Preference Dividend
Preference Dividend = `3, 36, 000 – `3, 02, 400 = ` 33, 600
Preference Dividend `33,600
Rate of Dividend = ×100 = ×100 = 8.4%
Preference share capital 4,00,000
31. (a) Calculation of EPS
Particulars Alternatives
A I: T Alternative- A III:
additional II: I Issue further
Debt Preference Shares Equity Shares
(`) (`) (`)
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 11, 40, 000 11, 40, 000
Taxes 40% (2, 64, 000) (4, 56, 000) (4, 56, 000)
Profit after taxes 3, 96, 000 6, 84, 000 6, 84, 000
Preference shares dividend ..... (4, 40, 000) .....
Earnings available to 3,96,000 2, 44, 000 6, 84, 000
equity Shareholders
Number of shares 8, 00, 000 8, 00, 000 10, 50, 000
Earnings per share 0.495 0.305 0.651

(b) For the present EBIT level, equity shares are clearly preferable. EBIT would need to increase
by `2,376 – `1, 500 = `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 indifference point, the
stronger the case that can be made for debt, all other things remain the same.
N :
Calculation of indifference point between debt and equity shares -
EBIT – ` 8,40,000 EBIT – `3,60,000
=
8,00,000 10,50,000
EBIT – ` 8,40,000 EBIT – `3,60,000
=
80 105
142 Financial Management PW
 (EBIT – 8,40,000)(105) = (EBIT – 3,60,000)(80)
(105)EBIT – 8,82,00,000 = (80)(EBIT) – 2,88,00,000
(25)(EBIT) = 5,94,00,000
5,94,00,000
EBIT = = `23,76,000
25
32. (i) Calculation of total value of the firm
Earnings available for equity holders (1,00,000 – 50,000)
Value of equity (S) = = = 3,33,333
Ke 0.15
Value of Debt (D) (given) = `5, 00, 000
Total value of the firm (V) = D + S = 5, 00, 000 + 3, 33, 333 = `8, 33, 333
S D  `3,33,333   `5,00,000 
(ii) Overall cost of capital ( Ko ) = Ke   + Kd   = 0.15  + 0.10   = 12.00%
V V  `8,33,333   `8,33,333 
EBIT `1,00,000
Or, K0 = = = 12.00%
V `8,33,333
(iii) Value of debt (D) = `5,00,000 + `2,00,000 = `7,00,000
Earnings available for equity holders (1,00,000 – 70,000)
Value of equity (S) = = =`2,00,000
Ke 0.15
Total value of the firm (V) = D + S = 7, 00, 000 + 2, 00, 000= `9, 00, 000
S D  `2,00,000   `7,00,000 
Overall cost of capital ( K o ) = K e   + K d   = 0.15  + 0.10  
V V  `9,00,000   `9,00,000 
= 11.11%
EBIT `1,00,000
or, K0 = = = 11.11%
V `9,00,000
33. 1. Valuation of firms
Particulars Levered Firm (`) Unlevered Firm (`)
EBIT 30,000 30,000
Less Interest on debt (10% × `1, 00, 000) 10,000 Nil
Earnings available to Equity shareholders 20,000 30,000
Ke 12.5% 12.5%
Value of Equity (S). 1, 60, 000 2, 40, 00
(Earnings available to Equity shareholders /Ke )
Debt (D) 1, 00, 00 Nil
Value of Firm (V) = S + D 2, 60, 000 2, 40, 000
Value of Levered company is more than that of unlevered company. Therefore, investor will sell
his shares in levered company and buy shares in unlevered company. To maintain the level of
risk he will borrow proportionate amount and invest that amount also in shares of unlevered
company.

Capital Structure 143

 2. Investment & Borrowings
Sell shares in Levered company (`1,60,000 × 15%) 24,000
Borrow money (`1,00,000 × 15%) 15, 000
Buy shares in Unlevered company 39, 000
3. Change in Return
Income from shares in Unlevered company (`39, 000 × 12.5%) 4,875
Less Interest on loan (`15, 000 × 10%) 1,500
Net Income from unlevered firm 3,375
Less Income from Levered firm (`24000 × 12.5%) 3,000
Incremental Income due to arbitrage 375
34. 1. Valuation of firms
Particulars Levered Firm (`) Unlevered Firm (`)
EBIT 30,000 30,000
Less Interest on debt (10% × `1,00,000) 10,000 Nil
Earnings available to Equity shareholders 20,000 30,000
Ke 20% 12.5%
Value of Equity (S) 1,00,000 2,40,000
(Earnings available to Equity shareholders/Ke)
Debt (D) 1,00,000 Nil
Value of Firm (V) = S + D 2,00,000 2,40,000
Value of Unlevered company is more than that of Levered company therefore investor will sell
his shares in Unlevered company and buy shares in Levered company. Market value of Debt
and Equity of Levered company are in the ratio of `1, 00, 000 `1,00,000 i.e. 1 1. To maintain
the level of risk he will lend proportionate amount (50%) and invest balance amount (50%)
in shares of Levered company.
2. Investment & Borrowings
Sell shares in Unlevered company (`2,40,000 × 15%) 36, 000
Lend money (`36, 000 × 50%) 18,000
Buy shares in Levered company (`36,000 × 50%) 18, 000
Total 36, 000
3.
Change in Return `
Income from shares in Levered company (`18, 000 × 20% ) 3,600
Interest on money lent (`18, 000 × 10%) 1,800
Total Income after switch over 5,400
Less Income from Unlevered firm (`36, 000 × 12.5%) 45, 500
Incremental Income due to arbitrage 900

144 Financial Management PW

35. Note that the ratio given in this question is not debt to equity ratio. Rather it is the debt to total
value ratio. Therefore, if the ratio is 0.6 , it means that capital employed comprises 60% debt and
40% equity.
K × D + Ke × S
KO = d
D+S
In this question total of weight is equal to 1 in all cases, hence we need not to divide by it.
K0 = 11% × 0 + 13% × 1 = 13.00%
K0 = 11% × 0.1 + 13% × 0.9 = 12.80%
K0 = 11.6% × 0.2 + 14% × 0.8 = 13.52%
K0 = 12% × 0.3 + 15% × 0.7 = 14.10%
K0 = 13% × 0.4 + 16% × 0.6 = 14.80%
K0 = 15% × 0.5 + 18% × 0.5 = 16.50%
K0 = 18% × 0.6 + 20% × 0.4 = 18.80%
Decision 2nd option is the best because it has lowest WACC.
36. (i) Statement showing total value of the firm
`
Net operating income (EBIT) 5, 00, 000
Less Interest on debentures (10% of `15,00,000) 1, 50, 000
Earnings available for equity holders 3, 50, 000
Total cost of capital (K0) (given) 15%
EBIT `5,00,000
Value of the firm ( V ) = = 33, 33, 333
k0 0.15
(ii) Calculation of cost of equity
Market value of debt (D) = `15,00,000
Market value of equity (S) = V – D = `33,33,3333 – `15,00,000 = `18,33,333
EBIT– Interest paid on debt `3,50,000
Ke = = = 19.09%
Market value of equity `18,33,333
or
S D
K0 = K e   + K d  
V V

V D  `33,33,333   `15,00,000 

= Ko   – Kd   = 0.15  – 0.10   = 19.09%
S S  `18,33,333   `18,33,333 
37. As per MM approach, cost of the capital (Ko) remains constant, and cost of equity increases linearly
with debt.
NOI
Value of a Firm =
K0
21,60,000
∴1,20,00,000 =
K0
Capital Structure 145
 21,60,000
∴ K0 = = 18%
1,20,00,000
D
Under MM approach, k e = k 0 + ( k0 – k d )
E
Statement of equity capitalization under MM approach

Debt Equity Debt/ Kd Ko Ko – kd D

Value (`) Value (`) Equity (%) (%) (%) Ke = Ko + (Ko − Kd )  
E
– 1,20,00,000 0.0000 NA 18.00 18.00 18.00
10,00,000 1,10,00,000 0.0909 7.00 18.00 11.00 19.00
20,00,000 1,00,00,000 0.2000 7.00 18.00 11.00 20.20
30,00,000 90,00,000 0.3333 7.50 18.00 10.50 21.50
40,00,000 80,00,000 0.5000 7.50 18.00 10.50 23.25
50,00,000 70,00,000 0.7143 8.00 18.00 10.00 25.14
60,00,000 60,00,000 1.0000 8.50 18.00 9.50 27.50
70,00,000 50,00,000 1.4000 9.00 18.00 9.00 30.60
80,00,000 40,00,000 2.0000 10.00 18.00 8.00 34.00
38. Here we are assuming that MM Approach 1958 Without tax, where capital structure has no
relevance with the value of company and accordingly overall cost of capital of both levered as
well as unlevered company is same. Therefore, the two companies should have similar WACCs.
Because SK Limited is all-equity financed, its WACC is the same as its cost of equity finance, i.e.
16 per cent. It follows that SK Limited should have WACC equal to 16 per cent also.
Therefore, Cost of equity in SK Ltd. (levered company) will be calculated as follows
2 1
K o = × K e + × K d = 16% (i.e. equal to WACC of SK Ltd.)
3 3
2 1
Or, 16% = × K e + × 10% Or, Ke = 19
3 3
39. (a) As per MM Model, Ko = Keu = 9.09%
Statement of Value of Firms
Particulars Firm A Firm B
EBIT (`) 5,000 5,000
Ko 9.09% 9.09%
Equilibrium value (`) 5,000 5,000
= 55,005.50 = 55,005.50
9.09% 9.09%
(b) Statement of value of Equity
Particulars Firm A Firm B
Equilibrium value 55,005.50 55,005.50
(–) Value of debt – 30,000
Value of equity 55,005.50 25,005.50

146 Financial Management PW

 Cost of equity of Firm A (unlevered) = 9.09%
Net Income 3,200
Cost of equity of Firm B (levered) = ×100 = × 100 = 12.80%
Value of equity 25,005.50
Or
 Debt   30,000  = 12.80%
Cost of equity of firm B = Ko + (Ko – Kd)   = 9.09 + (9.09 – 6)  
 Equity   25,005.50 
1,800
Cost of debt (Kd) = × 100 = 6%
30,000
40. Working Note
Net Income ( NI ) for Equity Holders
Market value of equity =
Ke
Net Income ( NI ) for Equity Holders
`25, 00, 000 =
0.21
Net Income for Equity Holders = 25,00,000 × 0.21 = `5,25,000
5,25,000
EBIT = = `7,50,000
1 − 0.30
(`in lakhs)
Particulars All Equity Debt and Equity
EBIT 7,50,000 7,50,000
(-) Interest – (75,000)
EBT 7,50,000 6,75,000
(-) Tax 30% 2,25,000 2,02,500
Income to shareholders 5,25,000 4,72,500

(a) Market value of company = Value of equity + Value of debt

= `25,00,000 + (5,00,000 × 0.30) = `26,50,000
The impact is that the market value of the company has increased by `1,50,000.
Net income to equity holders 4,72,500
(b) Ke = = = 0.219 = 21.98%
Equity value 26,50,000 − 5,00,000

(c) Kd = I × (1 – t) = 15% × (1 – 0.30) = 10.5%

Weighted Average Cost of Capital (WACC)
Source Amount Weights Cost of capital Weighted Average
(1) (2) (3) (4) Cost (5)= (3)x(4)
Equity 21,50,000 0.81 21.98 17.80
Debt 5,00,000 0.19 10.50 2.00
26,50,000 1 19.80
Weighted Average Cost of Capital (WACC) = 19.80%
The impact is that WACC has fallen by 1.20% due to benefit of lower cost of capital of debt.
Capital Structure 147
 41. Statement showing Profitability of Alternative Schemes for Financing (`in 00, 000)
Particulars Existing Alternative Schemes
(i) (ii) (iii)
Equity Share capital (existing) 10 10 10 10
New issues – 10 5 –
Total 10 20 15 10
7% debentures 10 10 10 10
6% debentures – – 5 10
Total 20 30 30 30
Debenture interest (7%) 0.7 0.7 0.7 0.7
Debenture interest (6%) – – 0.3 0.6
Total 0.7 0.7 1.0 1.3
Output (units in lakh) 1 1.5 1.5 1.5
Contribution per. Unit (`) (Selling price – 20 22 22 22
Variable Cost)
Contribution ( `lakh) 20 33 33 33
Less Fixed cost 10 15 15 15
EBIT 10 18 18 18
Less Interest (as calculated above) 0.7 0.7 1.0 1.3
EBT 9.3 17.3 17 16.7
Less Tax (40%) 3.72 6.92 6.8 6.68
EAT 5.58 10.38 10.20 10.02
Operating Leverage (Contribution /EBIT) 2.00 1.83 1.83 1.83
Financial Leverage (EBIT/EBT) 1.08 1.04 1.06 1.08
Combined Leverage (Contribution/EBT) 2.15 1.91 1.94 1.98
EPS (EAT/No. of shares) (`) 5.58 5.19 6.80 10.02
Risk – Lowest Lower than Highest
option (3)
Return – Lowest Lower than Highest
option (3)
From the above figures, we can see that the Operating Leverage is same in all alternatives though
Financial Leverage differs. Alternative (iii) uses the maximum amount of debt and result into the
highest degree of financial leverage, followed by alternative (ii). Accordingly, risk of the company
will be maximum in these options. Corresponding to this scheme, however, maximum EPS (i.e.,
`10.02 per share) will be also in option (iii).
So, if SK Ltd. is ready to take a high degree of risk, then alternative (iii) is strongly recommended.
In case of opting for less risk, alternative (ii) is the next best option with a reduced EPS of
`6.80 per share. In case of alternative (i), EPS is even lower than the existing option, hence not
recommended.

148 Financial Management PW

 Interest `7,50,000
42. (i) Value of Debt = = =`93,75,000
Cost of debt ( K d ) 0.08
Operating profit - Interest `34,50,000 –`7,50,000
(ii) Value of equity capital = =
Cost of equity ( Ke ) 0.16
= `1, 68, 75, 000
Increased Operating profit – Interest on Increased debt
(iii) New Cost of equity (Ke) after proposal =
Equity capital

=
( `34,50,000 +`14,25,000) – ( `7,50,000 +`6,00,000) = `35,25,000
= 0.209 or 20.9%
n1,68,75,000 `1,68,75,000
(a) Calculation of Weighted Average Cost of Capital (WACC) before the new proposal
Sources (`) Weight Cost of Capital WACC
Equity 1, 68, 75, 000 0.6429 0.160 0.1029
Debt 93, 75, 000 0.3571 0.080 0.0286
Total 2, 62, 50, 000 1 0.1315 or 13.15%
(b) Calculation of Weighted Average Cost of Capital (WACC) after the new proposal
Sources (`) Weight Cost of Capital WACC
Equity 1,68,75,000 0.5000 0.209 0.1045
Debt 1,68,75,000 0.5000 0.080 0.0400
Total 3,37,50,000 1 0.1445 or 14.45%

Capital Structure 149

 6 Leverages
CHAPTER

THEORY
Meaning of ‰ In financial analysis, leverage represents the influence of one financial
Leverage variable over some other related financial variable.
‰ These financial variables may be costs, output, sales revenue, Earnings
Before Interest and Tax (EBIT), Earning per share (EPS) etc.

Business Risk ‰ It refers to the risk associated with the firm’s operations. This risk
arises due to presence of fixed cost in the total cost.
‰ It is generally an unavoidable risk because a firm can’t operate without
incurring any fixed cost.

Financial Risk ‰ It refers to the risk associated with the firm’s financing. This risk arises
due to presence of interest and preference dividend.
‰ This risk can be avoided, if all the funds are raised from equity capital.

Operating Leverage ‰ It can be defined as the firm’s ability to use fixed operating costs to
magnify the effects of changes in sales on its earnings before interest
and taxes.
‰ Degree of operating leverage (DOL) is equal to the percentage increase
in the net operating income to the percentage increase in the output.
Contribution % Change in EBIT
‰ DOL = DOL =
EBIT % Change in Sales

Operating Break- ‰ It is the level of sale at which operating profit i.e. EBIT is zero.
even point
‰ Operating BEP (Units) = EBIT = Fixed Cost
EBT Contribution per unit
Fixed Cost
‰ Operating BEP (`) =
P / V Ratio

Margin of safety 1
(MOS) and ‰ Dol =
Margin of safety
Operating Leverage