From the following information determine optimal capital structure by calculation

1 of cost of capital.
Particulars Plan 1 Plan 2 Plan 3 Plan 4 Plan 5 Plan 6 Plan 7
Debt as a percentage
0 of total
0.1 capital0.2 0.3 0.4 0.5 0.6
Debt cost (Kd %)
6 6 6 6.5 7 7.5 8.5
Equity cost (Ke
14%) 14 14.5 15 16 18 19
Solution. Calculation of Cost of capital
Financial Capital Structure Specific Cost
Plan Debt Equity Debt Equity WACC (%)
1 0 1 0.06 0.14 [0.0 x 0.06 + 1.0 x 0.14] 100 = 14
2 0.1 0.9 0.06 0.14 [0.1 x 0.06 + 0.9 x 0.14] 100 = 13.2
3 0.2 0.8 0.06 0.15 [0.2 x 0.06 + 0.8 x 0.145] 100 = 12.8
4 0.3 0.7 0.07 0.15 [0.3 x 0.065 + 0.7 x 0.15] 100 = 12.45
5 0.4 0.6 0.07 0.16 [0.4 x 0.07 + 0.6 x 0.16] 100 = 12.40
6 0.5 0.5 0.08 0.18 [0.5 x 0.075 + 0.5 x 0.18] 100 = 12.75
7 0.6 0.4 0.09 0.19 [0.6 x 0.085 + 0.4 x 0.19] 100 = 12.7

From the above calculation we can observe that WACC has decreased from 15 per
cent to 12.4 per cent and there after increased, which was due to the use of heavy
debt. Hence, optimal capital structure is where the WACC is minimum that 12.4
per cent at 40 per cent debt and 60 per cent equity. In other words, fifth financial
plan is optimum capital structure.
 If debt is cheaper than equity why do companies not finance their assets with 80
2 per cent or 90 per cent debt ratio?

Capital structure it the mixture of the various types of long-term sources of funds
namely, equity share including retained earnings, preference shares debentures and
long-term loans form financial institution. It is also known as financial structure.

Companies can use any source of finance for their assets requirements. The
required capital can be raised in any one of the following financial plans.
(a) Fully equity share capital plan,
(b) Fully debt capital plan,
(c) Fully preference share capital plan,
(d) Combination of (a) and (b) in different proportions,
(e) A combination of (a), (b) and (c) in different proportions, and
(f) A combination of (a) and (c) in different proportions and so on.

Of all the sources of long-term finance debt is the cheapest source no doubt,
because the interest paid on debt is allowed for tax purpose. The company can
save tax due to the interest, but company cannot use debt beyond certain limit, up
to certain limit use of debt reduces overall cost of capital; beyond the limit it will
increase. This can be illustrated with the following example.

Finance
source
and their
cost Plan 1 Plan 2 Plan 3 Plan 4 Plan 5 Plan 6 Plan 7
Debt as a percentage
0 of total
10 capital20 30 40 50 60
Debt cost (Kd %)
7 7 7 7.5 8 8.5 9.5
Cost of Equity15
(Ke %) 15 15.5 16 17 19 20
You are required to find out optimal debt-equity mix of the company.
Solution. Calculation of debt-equity mix for financial plans

Financial Capital Structure Specific Cost (%) Weighted Average Cost of Capital (in
Plan Debt Equity Debt Equity %)
1 0 100 7 15 [0.0 x 0.07 + 100 x 0.15] 100 = 15
 2 10 90 7 15 [0.1 x 0.07 + 90 x 0.15] 100 = 14.2
3 20 80 7 15.5 [0.2 x 0.07 + 80 x 0.155] 100 = 13.8
4 30 70 7.5 16 [0.3 x 0.075 + 70 x 0.16] 100 = 13.45
5 40 60 8 17 [0.4 x 0.08 + 60 x 0.17] 100 = 13.40
6 50 50 8.5 19 [0.5 x 0.085 + 50 x 0.19] 100 = 13.75
7 60 40 9.5 20 [0.6 x 0.095 + 40 x 0.20] 100 = 13.7

From above table we can observe that the WACC has decreased from 15 per cent 13.4 per
cent and there after increased it was due to the use of debt. Company’s optimum debt-ration
is 40 per cent (i.e., out of total funds required for financing of assets, company can use 40 per
cent of debt funds and 60 per cent of equity funds). So, companies cannot finance their
assets with 80 per cent or 90 percent, since the WACC is increasing after 40 per cent.
 Calculate operating leverage. Interest Rs. 5,0000; sales Rs.
3 50,000; Variable cost Rs.
25,000; Fixed cost Rs. 15,000.

Solution. Computation of EBIT or

Operating Profit
Amount
Particulars Rs.
Sales 50,000
Less: Variable cost 25,000
Contribution 25,000
Less: Fixed cost 15,000
EBIT or Operating Profit 10,000

Operating leverage=Contribution ÷ EBIT or Operating profit =

Rs. 25,000 ÷ Rs.10,000 = 2.5
 AMC Company Ltd., provided the following information and requested you to
calculate (a) operating leverage with 4000 and 6000 quantity of sales, (b) operating
4 BEP (Q)

Selling price Rs. 300, variable cost Rs. 200, Fixed cost Rs. 2,40,000
Solution.
Calculation of EBIT
4000
Particulars units 6000 units

Sales revenue 12,00,000 18,00,000

Less: Variable cost 8,00,000 12,00,000
Contribution 4,00,000 6,00,000
Less: Fixed cost 2,40,000 2,40,000
EBIT or Operating Profit 1,60,000 3,60,000
(a) Operating leverage (OL) = Contribution ÷ EBIT
OL (4000 units) = 2.5; OL (6000 units) = 1.66
(b) Operating BEP (Q) = Fixed cost ÷ Contribution PV
= 2,40,000 / (300 – 200) = 2400 units
 BOL Ltd., currently selling 800 units per annum at the rate of Rs. 2000 PV. For manufacture of one unit t
company has to spend Rs. 1200 variable cost per unit and a fixed cost of Rs. 2,00,000. What is the operati
leverage at present level of activity ? Also calculate the operating leverage if the company sells 1200 units
5 annum.
Solution.
Calculation of EBIT

800 units 1200 units

Activity activity
Particulars level level
16,00,00
Sales at Rs. 2000 PV 0 24,00,000
Less: Variable cost 9,60,000 14,40,000
Contribution 6,40,000 9,60,000
Less: Fixed cost 2,00,000 2,00,000
EBIT or Operating Profit 2,40,000 7,60,000
Operating leverage = Contribution ÷EBIT 2.66 1.26
. For manufacture of one unit the
s. 2,00,000. What is the operating
if the company sells 1200 units per