CAPITAL STRUCTURE
Q.1. X Ltd is considering three different plans A, B, and C to finance its total project cost of
Rs 100 lakh.
Plan A
Plan B
Plan C
Equity capital (Rs 100 per share)
50
34
25
10% Debentures
50
66
75
100
100
100
Sales for the first 4 years of operations are estimated at Rs 100 lakh, Rs 125 lakh and Rs 150
lakh 80 lakh respectively and a 10 per cent profit before interest and taxes is forecast. The
tax is to be taken at 35 percent.
Compute EPS in each of the 3 alternative financing plans.
Q.2. Key information pertaining new financing plans of Hypothetical Ltd is given below:
Sources of funds
Financing plans
1
2
Equity
15,000 share of Rs 100 each
30,000 shares of Rs 100 each
Preference shares 12% 25,000 shares of Rs 100 each
Debentures Rs 5,00,000 at a coupon rate of 0.10
Rs 15,00,000 at a coupon rate of 0.11
Assuming 35% tax rate,
(1) Determine the two EBIT – EPS coordinates for each financial plan.
(2) Determine the (a) indifference point, and (b) financial break even point for each financing
plan.
(3) Which plan has more financial risk and why?
(4) Indicate over what EBIT range, if any, one plan is better than the other.
(5) If the firm is fairly certain that its EBIT will be Rs 12,50,000, which plan would you
recommend, and why?
Q.3. Hypothetical Ltd is in need of Rs 1,00,000 to finance its increased net working capital
requirements. The financial manager of the company believes that its various financial costs
and share price will be unaffected by the selection of a particulars plan, since a small sum is
involved. Debentures will cost 10%, preference shares 11%, and equity shares can be sold
fore Rs 25 per share. The tax rate is 35%.
Sources of funds
Financial plans (percent)
1
2
3
Equity shares
100
30
50
11% Preference shares
0
10
20
10% Debentures
0
60
30
(i) Determine the financial break even point.
(ii) Which plan has greater risk? Assume EBIT level of Rs 50,000.
(iii) Which plan should the Co. opt for?
Q.4. The Adarsh Ltd is considering methods to finance its investment proposal. It is estimated
that initially Rs 4,00,000 will be needed. Two alternative methods of raising funds are available
to the firm: (a) Issue of 15% loan amounting to Rs 2,00,000 and issue of 2,000 equity shares
of Rs 100 each; and (b) Issue of 4,000 equity shares of Rs 100 each. The appropriate tax rate
is 35%.
(i) Assuming operating profits (EBIT) of: (a) Rs 70,000 and (b) Rs 80,000 which financing
proposal would you recommend and why?
(ii) Compute the indifference point of the two financial plans and compute financial BEP.
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Q.5. A new project consideration by your company requires a capital investment of Rs 150
lakh. The required funds can be raised either through the sale of equity shares or borrowed
from a financial institution. Interest on term loans is 15% and tax rate is 35%. If the debt equity
ratio insisted by the financing agencies is 2:1, calculate the indifference point for the project.
Explain its meaning. Also, prepare a verification table and financial BEP.
Q.6. (a) The existing capital structure of XYZ ltd is as under:
Equity shares of Rs 100 each
Rs 40,00,000
Retained earnings
Rs 10,00,000
9% Preference Shares
Rs 25,00,000
7% Debentures
Rs 25,00,000
The existing rate of return on the company’s capital is 12% and the income tax rate is 50%.
The company requires a sum of Rs 25,00,000 to finance its expansion programme for which
it is considering the following alternatives:
(i) Issue of 20,000 equity shares at a premium of Rs 25 per shares.
(ii) Issue of 10% Preference shares.
(iii) Issue of 8% Debentures.
It is estimated that the Price Earning Ratio in the cases of Equity, Preference and Debentures
financing would be 20, 17, and 16 respectively.
(a) Which of the above alternative would you consider to be best?
(b) Give reasons for your choice in (a) above.
Q.7. Espee Ltd. desires to plan its capital structure with total outlay of Rs.1 crore. It anticipates
the profit before interest and tax @ 20% on capital. The tax rate applicable is @ 40%. The
following three alternative capital structure are available.
Source
I
II
III
Equity Capital
30%
50%
60%
14% Debentures
70%
50%
40%
All shares and debentures will have F.V. @ Rs.100/- are to be fully called up with application.
The company expects to have pay out ratio of 75%. The reasonable return (dividend) on
equity shares is 10%.
(a) Suggest the structure to be adopted to maximize returns to equity holders.
(b) Calculate market price of equity shares.
Q.8. A growing company XYZ has two alternative choi8ce between 15% debt issue and equity
issue to finance its expansion programme. XYZ’s pre-expansion income statement is as
under:
Sales at current selling price
45,00,000
Production capacity at current selling price
60,00,000
Fixed Cost
5,00,000
Variable Cost
30,00,000
EBIT
10,00,000
Interest @ 12.5%
1,00,000
EBT
9,00,000
Income Tax @ 50%
4,50,000
EAT
4,50,000
EPS
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The expansion programme is estimated to cost Rs.5,00,000. If it is financed through
debt the rate on new debt will be 15% and the P/E ratio will be 12 times. Expansion will
generate additional sales of Rs.12,75,000. No additional fixed costs needed for the expansion
programme. If the company XYZ is to follow a policy of maximizing the market value of its
shares, which form of financing should be employed by the company and why? Give full
working.
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Q.9. The following figures of Kwicks Ltd are presented to you.
Earning Before Interest and Tax
Less: Debenture interest @ 8%
80,000
Long Term Loan Interest @ 11% 2,20,000
Less: Income Tax
No. of Equity Shares of Rs.10 each
EPS
Market Price of Share
P/E Ratio
23,00,000
3,00,000
20,00,000
10,00,000
10,00,000
5,00,000
Rs.2
Rs.20
Rs.10
The company had undistributed reserves and surplus of Rs.20 lakhs. It is in need of Rs.30
lakhs to pay off debentures and modernize its plans. It seeks your advice on the following
alternatives modes of raising finance.
(a) Raising Entire amount as termed loan from Bank @ 12%
(b) Raising part of the funds by issue of 1,00,000 shares of Rs.20 each and the rest by Term
Loan @ 12%.
The company expects to improve its rate of return by 2% as result of modernization, but P/E
Ratio is likely to go down to 8 if the entire amount is raised as Term Loan.
(a) Advice the company on the Financial Plan to be selected.
(b) It is assumed that there will be no change in the P/E ratio if either of two alternative are
adopted, would advice still hold good?
Q.10. A company provides you with the following figures:
Earning Before Interest and Tax
Less: Debenture interest @ 7%
Less: Income Tax @ 50%
Profit after Tax
No. of Equity Shares of Rs.10 each
EPS
Market Price of Share
P/E Ratio
The company has undistributed reserves of
23,50,000
3,50,000
20,00,000
10,00,000
10,00,000
4,00,000
Rs.2.5
Rs.25
Rs.10
60,00,000
The company needs Rs.20,00,000 for expansion: this amount will earn at the same rate as
funds already employed. You are informed that debt equity ratio
Debt
Debt + Equity
higher than 35% pushes the P.E. ratio down to 8 and raises the interest rate on additional
amount borrowed to 8%. You are required to ascertain the probable price of the share if:
(a) The additional funds are raised as a loan; or
(b) The amount is raised by issuing equity shares
Q.11. ABC Ltd. needs Rs.12 Lakhs for the installations of a new factory which would give an
annual EBIT of Rs.2 Lakhs. The company has the objective of maximizing the EPS. It is
considering the possibility of issuing equity shares plus raising a debt of Rs.2 Lakhs, Rs.6
Lakhs, or Rs.10 Lakhs. The current market price per share is Rs.40, which is expected to
drop to Rs.25 per share if the market borrowings were to exceed Rs.7.5 lakhs. The cost of
borrowing are as under: Cost of Borrowing
Up to Rs.2.5 Lakhs
10%
Up to Rs.2,50,001 to Rs.6,25,000
14%
Up to Rs.6,25,001 to Rs.10 Lakhs 16%
Assuming a tax rate of 40% work out the EPs and the scheme which would meet the
objective of the company.
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