FM II: Chapter one: Exercise with solutions:
Q1. A firm has two alternative plans for raising additional funds of Br. 1,000,000.
1. issue of 10,000 bonds of Br 100 each bearing 10% interest per annum.
2. issue of 4000 bonds of Br 100 each bearing 10% interest per annum and balance by the
issue of 12% pref-shares.
you are required to calculate EBIT at the financial B.E.P for each plan assuming a tax rate of 50%.
EBIT at the financial break-even point is computed as:
EBIT= I + Dp/ (1-T)
Solution:
Plan 1- as the firm employs only debt and not pref-share capital the financial B-E-P shall be equal to
the fixed interest charges; or Financial B-E-P = Fixed interest charges = Br 100,000
Plan 2- as the firm employs both debt and pref-share capital, the financial B-E-P can be; Financial B-
E-P = i+Dp/(1-t) = 40,000+72000/(1-0.5) = 40,000+144,000 = Rs 184,000.
Q2. A company’s expected net operating income (EBIT) is Br.100,000 the company has issued Br.
500,000, 10% bond of Br 100 each. The cost of equity is 12.5%, assuming no taxes.
Find out overall cost of capital and the value of the firm, according to NI approach.
Solution:
Net operating income Br 100,000
Less: int on debentures 50,000
NI …………………… 50,000
Cost of equity (Ke) =12.5%
value of equity (E) shares= NI/Ke = 400,000
Value of debt (B) =Br 500,000
Total value of the firm (E+B=V) =Br 900,000
Overall cost of capital(Ko) =EBIT/V =11.1%.
Alternatively,
Ko=w1(Kd)+w2(Ke) = 500,000/900,000*(0.10)+400,000/900,000*(0.125)=11.10%.
OR, Ko =Ke-(Ke-Kd)B/V=11.10%
Assuming that the above company increases the debt from Rs 500,000 to Rs 600,000 and the cost of
debt and equity remains at the same level. Calculate the overall cost of capital, value of the firm and
the market value of equity shares.
Q3. A company’s expected annual net operating income (EBIT) is Rs 100,000. the company has
500,000, 10% debentures. The overall cost of capital is 12.5%. Calculate the value of the firm and
value of equity, according to NOI approach.
Solution:
Net operating income (EBIT) ………………….Rs 100,000
Overall cost of capital(Ko)……………………………… 0.125
Total value of the firm(V=EBIT/Ko) ………………….800,000
Market value of the debt (B)……………… ………….500,000
Total market value of the equity(S=V-B) ……………..300,000
Cost of equity (Ke) =NI/V =(EBIT-Interest)/market value of shares. = 100,000-50,000/300,000 =
16.67%
Ke=Ko+(Ko-Kd)B/S=0.125-(0.125-0.1)500,000/300,000=16.67%
If the company increases the debt from Rs 500,000 to 600,000, the Ke and the value of the firm.
calculate—the value of the firm and cost of equity.
Q4. Assume that there are two firms L and U which are identical in all the respects except that the
firm L has 10% Br 500,000 bond. The EBIT of both the firms are Br 80,000. the cost of equity of the
firm L is higher at 16% and firm U is lower at 12.5%.
Calculate the total market values of the firms.
Solution:
Firm L Firm U
EBIT 80,000 80,000
Less ; Interest 50,000 nil
NI 30,000 80,000
Cost of equity -Ke 0.16 0.125
Market value of equity- 187,500 640,000
E
Market value of debt-B 500,000 nil
Total value of the firm- 687,500 640,000
V
WACC (Ko) =EBIT/V 11.63% 12.5%
(80,000/687,500)
Q5. There are two firms X and Y which are exactly identical except that X does not use any debt in its
financing, while Y has Rs 100,000. 5% Debentures in its financing. Both the firms have earnings
before interest and Taxes of Rs 25,000 and the equity capitalization rate is 10%. Assuming the
corporation tax of 50%.
Calculate the value of the firm using MM approach.
Solution:
Vu = (EBIT × (1 − Tc))/Ru = EBIT/Ko*(1-t) = 25,000/0.10*(1-0.5) • = 250000*0.5= Rs 125,000.
VL= Vu + Tc× D= Vu+Bt= 125,000+100,000*0.50 • = 125,000+50,000= Rs 175,000.