CAPITAL STRUCTURE PROBLEMS

M COM SEMESTER – I

ADVANCED FINANCIAL MANAGEMENT – CAPITAL STRUCTURE THEORIES

PROBLEM: 1

1. X Co. has a net operating income of Rs 200,000 on an investment of Rs 1,000,000 in assets. It

can raise debt at a 16 per cent rate of interest. Assume that taxes do not exist.

(a) Using the NI approach and an equity-capitalization rate of 18 per cent, compute the total
value of the firm and the weighted average cost of capital if the firm has (i) no debt, (ii) Rs
300,000 debt, (iii) Rs 600,000 debt.

(b) Using the NOI approach and an overall capitalization rate of 12 per cent, compute the total
value of the firm, value of shares and the cost of equity if the firm has (i) no debt, (ii) Rs
300,000 debt, (iii) Rs 600,000 debt.

PROBLEM: 2

Firm L and Firm U are in the same risk class and are identical in every respect except that
Firm L is levered and Firm U is unlevered. Firm L has 12 per cent Rs 400,000 debentures
outstanding. Both firms earn 18 per cent before interest and taxes on their total assets of Rs
800,000. Assume a corporate tax rate of 50 per cent and a pure equity capitalisation rate of 15
per cent.

(a) Compute the total value of the firms using (i) the NI approach, (ii) the NOI approach.

(b) Using the NOI approach, calculate the after-tax weighted average cost of capital for both
the firms. Which of the two firms has an optimum capital structure and why?

(c) According to the NOI approach, the values for Firms A and B computed in part (a) using
the NI approach are not in equilibrium. Under such a situation, an investor can secure
same return at lower cash outlay through the arbitrage process. Assume that an investor
owns 5 per cent of L’s shares, show the arbitrage process. When would this arbitrage
process stop?

DR. P SRI RAM, FACULTY OF COMMERCE & MANAGEMENT STUDIES, GOA UNIVERSITY, GOA,
E-mail: padylasriram@yahoo.co.in Page 1
 CAPITAL STRUCTURE PROBLEMS

PROBLEM: 3

The values for two firms X — an unlevered firm and Y—a levered firm with Rs 600,000 debt at 6
per cent rate of interest is given as below. An investor holds Rs 20,000 worth of Y’s shares. Show
the process by which he can earn same return at a lesser cost.

X Y

Rs Rs

Net operating income, 200,000 200,000

Cost of debt, INT = kd D — 36,000

Net income, NI 200,000 164,000

X Y

Rs Rs

Equity-capitalization rate, ke 0.111 0.125

Market value of equity, E 1,800,000 1,312,000

Market value of debt, D — 600,000
Total value of firm, V = E + D 1, 800,000 1,912,000
Overall capitalization rate, ko 0.1111 0.1046

DR. P SRI RAM, FACULTY OF COMMERCE & MANAGEMENT STUDIES, GOA UNIVERSITY, GOA,
E-mail: padylasriram@yahoo.co.in Page 2
 CAPITAL STRUCTURE PROBLEMS

PROBLEM: 4

Two firms A and B are identical in all respect except that B has Rs 500,000 debt outstanding at a 6
per cent rate of interest. The values of the two

A B

Rs Rs

Net operating income 150,000 150,000

Cost of debt, kd — 30,000

Net income NI 150,000 120,000

Equity-capitalization rate, ke 0.10 0.15

Market value of equity, E 1500,000 800,000

Market value of debt, D — 500,000
Total value of firm, V = E + D 1,500,000 1,300,000
Overall capitalisation rate, ke 0.10 0.1154

Assume that an investor owns 10 per cent of A’s shares. How can the investor obtain same
return at a lower cost?

PROBLEM :5

Sppose X = Rs 50,000, kd = 0.06, Eu = Vu = Rs 500,000, El = Rs 280,000. Dl = Rs 250,000

and Vl = Dl + El = Rs 530,000. Calculate the cost of equity and the weighted average cost of
capital for two firms. If an investor owns 5 per cent of the levered firm’s shares, how can he be
benefited by resorting to the arbitrage process?

DR. P SRI RAM, FACULTY OF COMMERCE & MANAGEMENT STUDIES, GOA UNIVERSITY, GOA,
E-mail: padylasriram@yahoo.co.in Page 3
 CAPITAL STRUCTURE PROBLEMS

PROBLEM: 6

A new company proposes to invest Rs 10 lakh in assets and will maintain its capital structure at
book value. It is expected to earn a net operating income of Rs 160,000. The company wants
to have an optimum mix of debt and equity. The cost of debt and the equity-capitalization rate
at different debt-equity ratio are as follows:

(a) What is the optimum capital structure for this company?

(b) If the M-M hypothesis is valid, what should be the equity-capitalization rate at different
debt-equity ratios?

Equity-capitalization

Debt-Equity Ratio Cost of Debt Rate

— — 0.125
10: 90 0.05 0.130
20: 80 0.05 0.136
30: 70 0.06 0.143
40: 60 0.07 0.160
50: 50 0.08 0.180
60: 40 0.10 0.200

PROBLEM :7

The values for the two firms X and Y in accordance with the traditional theory are given below:

X Y
Rs Rs
Expected net operating income, 50,000 50,000
Total cost of debt, kd D = INT 0 10,000
Net income, – INT 50,000 40,000
Cost of equity, ke 0.10 0.11
DR. P SRI RAM, FACULTY OF COMMERCE & MANAGEMENT STUDIES, GOA UNIVERSITY, GOA,
E-mail: padylasriram@yahoo.co.in Page 4
 CAPITAL STRUCTURE PROBLEMS

Market value of shares, E 500,000 360,000

Market value of debt, D 0 200,000
Total value of firm, V = E + D 500,000 560,000
Average cost of capital, ko = X/V 0.10 0.09
Debt–equity ratio 0 0.556

Compute the values for firms X and Y as per the M-M thesis. Assume that (i) corporate
income taxes do not exist and (ii) the equilibrium value of ko is 12.5 per cent.

PROBLEM: 8

M /s Nagu Ltd., has a share capital of Rs. 1,00,000 divided into 10,000 equity sharp-s of Rs. 10
each fully paid. It has a major expansion programme requiring an investment of another Rs.
50,000. The management is considering the following alternatives for raising this amount.

(a) Issue of 5, 000 Equity shares of Rs. 10 each

(b) Issue of 5,000 12% Preference shares of Rs. 10 each
(c) Issue of 10% Debentures of Rs. 50,000
The company’s present earnings before interest and taxes (EBIT) are Rs. 4 0,000 p.a. You are
required to calculate the effect of each of the above modes of financing of the EPS (Earnings
Per Share) assuming ( i) EBI T continues to be the same even after expansion. (ii) EBIT
increases by Rs. 10,000. Assume tax rate at 50%.

PROBLEM: 9

In considering the most desirable capital structure for a company, the following estimates of
the cost of debt and equity capital (after tax) have been made at various levels of debt- equity
mix.

Debt as % of Total 0 10 20 30 40 50 60
Capital
Cost of Debt 5.0 5.0 5.0 5.5 6.0 6.5 7.0
Cost of Equity 12.0 12.0 12.5 13.0 14.0 16.0 20.0

DR. P SRI RAM, FACULTY OF COMMERCE & MANAGEMENT STUDIES, GOA UNIVERSITY, GOA,
E-mail: padylasriram@yahoo.co.in Page 5
 CAPITAL STRUCTURE PROBLEMS

You are required to determine the optimal debt-equity mix for the company by calculating
composite cost of capital.

Problem: 10

A new project is under consideration by Ram Ltd. which requires a capital investment of Rs. 150
Lakhs. Interest on term loan is 12% and tax rate is 50%. If the debt equity ratio insisted by the
financing agencies is 2 :1, calculate the point of indifference for the project.

Problem: 11

i) Murugappa & Co expects a net income of Rs. 80,000. It has 8% Debentures worth Rs. 2,00,000.
The equity capitalization rate of the company is 10%. Calculate the value of the firm and overall
cost of capital rate according to the Net Income approach. (Ignoring income tax). (ii) If Debenture
debt is increased to Rs. 3,00, 000 what shall be the value of firm and the overall cost of capital ?

Problem: 12

(i) SLM Ltd expects a net operating income of Rs. 2, 00,000. It has 6% Debentures worth Rs.
10,00,000. The overall capitalization rate is 10%. Calculate the value of the firm and the equity
capitalization rate according to NOI approach.
(ii) If the debenture debt is decreased to Rs. 7,50,000 what will be effect on the value of the firm
and the equity capitalization rate ?

Problem: 13

Two firms B and S are identical in all respects except the degree of leverage. Firm B has 6% of
debt of Rs. 3.00 lakhs while firm S has no debt. Both the firms are earning an EBT of Rs. 1,20,000
each. The equity capitalization rate is 10% and the corporate tax is 60%. You are required to
compute the market value of the two firms.

DR. P SRI RAM, FACULTY OF COMMERCE & MANAGEMENT STUDIES, GOA UNIVERSITY, GOA,
E-mail: padylasriram@yahoo.co.in Page 6