CAPITAL STRUCTURE THEORIES

1. A firm is expected to generate net operating earnings of Rs.20,00,000 which market capitalizes at that rate ke, at 20%. Assume that it has Rs. 25,00,000 in de t at 1!% interest, gi"en this information, calculate "alue of firm using #$ approach. 2. Assuming no taxes and gi"en the earning efore interest and taxes%&'$(), $nterest %$), at 10% and e*uit+ capitalization rate %,), elow, calculate the total market "alue of each firm using #$ approach.irms &'$( $ , / 2,00,000 20,000 12% 0 1,00,000 !0,000 1!% 2 5,00,000 2,00,000 15% 3 !,00,000 2,40,000 15% Also determine the weighted a"erage cost of capital for each firm. 1. %a) A compan+ expects a net income of Rs.50,000. $t has Rs. 2,00,000 , 5% 6e entures. (he e*uit+ capitalization rate of the compan+ is 10%. 7alculate the "alue of the firm and o"erall capitalization rate according to #et $ncome Approach %ignoring tax). % ) $f the de enture de t is increases to Rs. 1,00,000, what shall e the "alue of firm. 4. (he operating income of a firm is Rs. 50,000. (he cost of de t is 10%. 8utstanding de t is Rs. 2,00,000. $f the o"erall cost of capital is 12.5%, what would e the total "alue of the firm and the e*uit+ capitalization rate9 5. %a) A compan+ expects a net operating income of Rs. 1,00,000. $t has Rs. 5,00,000 !% de entures. (he o"erall capitalization rate is 10%. 7alculate the "alue of the firm and the e*uit+ capitalization rate according to #et 8perating $ncome Approach. % ) $f the de enture de t is increased to Rs. :,50,000. 3hat will e the effect on the "alue of the firm and e*uit+ capitalization rate9 !. ;ummer <td. And 3inter <td. are identical in all respects including risk factor except for 6e t= &*uit+ >ix. ;ummer <td. ha"ing issued 12% de entures of Rs. 10 lakhs, while winter <td. issued onl+ e*uit+ capital. 'oth the companies earn 24% efore interest and taxes on their total assets of Rs. 50 lakhs. Assuming the corporate effecti"e tax rate of 40% and capitalization rate of 15% for an all e*uit+ compan+. 7ompute the "alue of summer <td. and 3inter <td. using %i) #et $ncome Approach and %ii) #et operating income approach.

:. %a) A firm has &'$( of Rs. 40,000. (he firm has 10% de entures of Rs. 1,00,000 and its current e*uit+ capitalization rate is 1!%. 7alculate current "alue of firm and o"erall cost of capital using traditional approach. % ) $f firm is considering to increase its le"erage issuing additional Rs. 50,000 de enture and using the proceeds to retire that amount of e*uit+. ?owe"er if firm increases proportion of de t ,i would rise to 11% and ,e to 1:%. 3hat will e the effect on the "alue of the firm and o"erall capitalization rate9 @ ) $f firm is considering to increase its le"erage issuing additional Rs. 1,00,000 de enture and using the proceeds to retire that amount of e*uit+. 6ue to increased financial risk , ,i would rise to 12.5% and ,e to 20%. 3hat will e the effect on the "alue of the firm and o"erall capitalization rate9 5. 7ompanies A and < are identical in e"er+ aspect, except that the former does not use de t in its capital structure, while the later emplo+s Rs. !,00,000 of 15% de t. Assuming thata. All the >> assumptions are met . 7orporate tax rate is 50% c. (he &'$( is Rs. 2,00,000 d. (he e*uit+ capitalization of the unle"ered compan+ is 20%, 3hat will e the "alue of firms A B <9 Also determine the weighted a"erage cost of capital for oth the firms.
C. (he following is the data regarding two companies D/E and D0E elonging to the same e*ui"alent risk class-

#um er of ordinar+ ;hares >arket Frice per share !% 6e entures Frofit efore interest

7ompan+ / 7ompan+ 0 C0,000 1,50,000 Rs. 1.2 Rs. 1 !0,000 GGGGGG Rs. 15000 Rs. 15000

All profit after de entures interest are distri uted as di"idends. &xplain how under >odigilani B >iller approach, an in"estor holding 10% of shares in 7ompan+ D/E will e etter off in switching his holding to 7ompan+ D0E. (MU MMS 2010)

10. (he two companies, H B R, elong to an e*ui"alent risk class. (hese two firms are identical in e"er+ respect except that H compan+ is unle"ered while 7ompan+ R has 10% de entures of Rs. 10 lakh. (he other rele"ant information regarding their "aluation and capitalization rates are as follows-

Farticulars &'$( <ess- $nterest &A(&;? ,e >arket Ialue of &*uit+ %;) >arket Ialue of 6e t %') (otal Ialue of .irm %IJ;K') $mplied o"erall cost of capital%,o) 6e t &*uit+ Ratio %'=;)

.irm F .irm H :,50,000 :,50,000 1,00,000 7,50,000 4,50,000 0.15 0.2 50,00,000 22,50,000 10,00,000 50,00,000 52,50,000 0.15 0.141 0 1.11

%a) An in"estor owns 10% e*uit+ share of compan+ H. ;how the ar itrage process and the amount + which he could reduce his outla+ through the use of le"erage. % ) According to >odigilani B >iller, when will this ar itrage process come to an end9

11. (he companies A77 7ements and 6almia 7ements elong to same risk class and are identical in e"er+ fashion except A77 7ements uses de t while 6almia 7ement does not. (he le"eraged compan+ has Rs.C,00,000 de enture carr+ing 10% rate of interest. 'oth firms earn 20% efore interest and taxes on their total assets of Rs. 10 lakhs. Assume perfect capital market, rational in"estors and so onL 'oth companies pa+ tax at 40% and capitalization rate for an all e*uit+ compan+ is 15%. 0ou are re*uired toa. 7ompute the "alue of the two firms using the #et $ncome and >odigilaniG>iller Approach. . Asing the >.>. approach, 7ompute the o"erall capitalization rate for oth the companies.
(MU MMS 2011)

12. .ollowing information is a"aila le from the ooks of /02 <td-

;ales 7ost of Raw >aterials <a our cost of manufacturing $nterest on 'orrowings

Rs. in <akhs 500 200 100 !0

(he capitalization rate for de t is 10% and the capitalization rate for the entire firm is 12.5%. Assuming that the firm does not retain an+ earnings and there is no tax, As per #8$ approacha) 3hat is the total market "alue of firm9 ) 3hat is the market "alue of de t of the firm9 c) 3hat is the market "alue of the e*uit+ of the firm9 d) 3hat is the e*uit+ capitalization rate9 (MU MMS 2009)