1. (a) What is bonus issue of shares and why do companies make bonus issue?

Bonus shares refers to the distribution or issue of shares in addition to the ca

sh divided (known as stock divided in the U.S.A.) to the existing shareholders.
The main reason for issuing such bonus shares is to increase the number of outst
anding shares of the company.
The shares are distributed proportionately. Thus, a share holder retains his pro
portionate ownership of the company. The declaration of bonus shares will increa
se the paid up capital. A bonus issue represent a recapitalization of the owners
equity portion i.e. the reserves and surplus. It is merely an accounting transf
er from reserves and surplus to paid-up capital.
(b) A company incurs variable cost of Rs.52 per unit of product manufactured.
It also incurs fixed cost of Rs.6,40,000 per annum. The selling price per unit i
s Rs.60. During last year the company manufactured and sold 1,20,000 units of it
s products. The company has 1,50,000 equity shares of Rs.10 each outstanding. I
t has also taken long term debt of Rs.8,50,000 at an interest rate of 12% per an
num. Tax rate is 30% . Comment on the sensitivity of the firm towards charges in
output by computing degree of operating leverage, degree of financial leverage
& degree of total leverage and EPS ?
Solution.:
Sales ( 120000 X 60 )
72,00,000
Less: Variable Cost ( 120000 X 52 )
62,40,000
Contribution
9,60,000
Less: Fixed Cost
6,40,000
Operating Profit (EBIT)
3,20,000
Less: Debentures ( 850000x12 )
100
1,02,000
EBT
2,18,000
Less: Tax 30%
65,400
EAT
1,52,600
Î EPS = 152600
150000
= 1.0173
(i) Financial Leverage :-
DFL = EBIT
ε EBIT â I
= 320000
320000-102000
= 1.46Times
(ii) Operating Leverage :-
DOL = 9,60,000
3,20,000
= 3.0 Times
(iii) Composite / Total Leverage :-
DTL = C Or DTL = DFL X DOL
EBT = 1.46 X 3.0
 = 9,60,000 = 4.38
2,18,000
= 4.40
Conclusion:
I. Financial leverage is 1.46 times that of equity.
II. Operating leverage is 3.0 times that of equity.
III. Total leverage is 4040 times that of equity.
(c) Briefly explain the necessity of investment in working capital and the fact
ors affecting the level of such investments?
Necessity of investment in working capital :-
I. To carry on smoothly the day today activities of a business concern.
II. It is useful to meet the credit obligation on date
III. It is helpful to effectively face crisis situations.
IV. It is helpful in monitoring liquidity position of the company.
V. It is helpful in maintaining optimum balance between current working cap
ital.
VI. It is helpful in maintaining optimum balance between current assets and
current liability.
VII. It increases the goodwill of the company.

Factors affecting the working capital:-

I. Nature of the business
II. Scale of operations.
III. Sales and demand conditions.
IV. Manufacturing cycle.
V. Rate of stock turn over.
VI. Credit policy
VII. Company policies
VIII. Government policies
IX. Fluctuations in prices of raw materials.
X. Type of production.
XI. Market condition.
XII. Trade practices prevailing in the industry
XIII. Competitive situation
2. (a) What is preferential allotments of shares?
Preferential allotment of shares means allotting the shares in respect o
f preference given to those members whose applications are received first. It is
the first preference to those whose application for share received first.
It is also, when no of application are received more than number of shar
es to be issued. Then in that case directions of a company have the authority to
issue shares. It is also preference to those who demand first.

(b) Explain in detail the Net Income approach to capital structure of a fir
m
Net Income Approach :-
It is developed by the Mr.Durand under this approach, the cost of debt and cost
of equity are assumed to be independent to the capital structure. The weighed av
erage cost of the firm rises with the increased use of leverage.
The essence of the net income approach, the overall cost of capital is
lower and the firm value increases, it is with the increase in the portion of d
ebt capital in the capital structure.
Assumptions:-
I. Markets are perfect.
II. There are no corporate taxes.
III. Cost of debt is less than the cost of equity.
IV. The rise perception of investors does not change in the use of debt.
Therefore V = S+D Where V = Market value of the firm
D = Market value of the debentures
S = Net Income
Equity capitalization rate
Ko = EBIT Ko= Overall cost of capital
V
(c) Susheel Corporation has the following book value capital structure:

Equity capital (10 million shares Rs.10 par) Rs. 100 million
Preference capital 11% (1,00,000 shares Rs.100 par) Rs. 10 million
Retained earnings Rs. 120 million
Debentures 13.5% (5,00,000 debentures Rs.100par) Rs. 50 million
Term loans 12% Rs. 80 million
Rs. 360 million
The next expected dividend per share is expected dividend per share is Rs.1.50.
The dividend per share is expected to grow at the rate of 7%. The market price p
er share is Rs.20 Preference stock, redeemable after 10 years, is currently sell
ing for Rs.75 per share. Debentures redeemable after 6 years are selling for Rs.
80 per debenture. The tax rate for the company is 50%. Compute the average cost
of capital using (a) book value proportions and (b) market value proportions.
Ans : Calculation of average cost of capital using Book Value Proportion:
Sources of funds Amount Specific ( K ) Weights ( W ) K x W
(i) Equity capital 1,00,00,000 0.1450 0.2770 0.0403
(ii) Preference Cap 10,00,000 0.1100 0.0270 0.00305
(iii) Retained earn. 1,20,00,000 0.0725 0.3330 0.0242
(iv) Debentures 50,00,000 0.0675 0.1388 0.009369
(v) Term Loans 80,00,000 0.0600 0.2200 0.0132
3,60,00,000 0.090 (9.0%)
Calculation of specific cost of capital
(i) Equity capital :-
Ke = 1.50 + 0.07 = 0.145
20
(ii) Preference Capital :-
Kp = 10,00,000 x 11 = 1,10,000
100
Î 1,10,000 = 0.11
10,00,000
(iii) Retained Earnings :-
Kr = 0.145 x 0.5 = 0.0725
(iv) Debentures :-
Kd = 6,75,000 ( 1- 0.50 )
50,00,000
= 0.0675
(v) Term Loans :-
Kt = 9,60,000 ( 1-0.50 )
80,00,000
 = 0.06
Computation of weights to each source of funds :-
(i) Equity capital :-
= 1,00,00,000 x 100
3,60,00,000
= 27.77%
(ii) Preference Capital :-
= 10,00,000 x 100
3,60,00,000
= 2.77% ( 0.0277 )
(iii) Retained Earnings :-
= 1,20,00,000 x 100
3,60,00,000
= 33.33%

(iv) Debentures :-
= 50,00,000 x 100
3,60,00,000
= 13.88%
(v) Term Loans :-
= 80,00,000 x 100
3,60,00,000
= 22.22%

Calculation of specific cost of capital using Market Value :

(i) Equity capital :-
Ke = 1.50 + 0.07 = 0.145
20
(ii) Preference Capital :-
D + MV - NP
n
Kp = _____________________
MV + NP
2

1.5 + 100 - 75
10
___________________
100 + 75
2
= 0.045

(iii) Retained Earnings :-

Kr = 0.145 x 0.5 = 0.0725
(iv) Debentures :-
I + MV - NP
 n
Kd = _____________________ x ( 1-0.50 )
MV + NP
2

13.5 + 100 - 80
6
Kd = _____________________ x ( 1-0.50 )
100 + 80
2
= 0.0935

(v) Term Loans :-

Kt = 0.06
Weights of new values of funds :-
(i) Equity = Same