FINANCIAL MANAGEMENT

CAPITAL STRUCTURE
QUESTIONS

Question 1

Amor Ltd., a profit making company, has a paid-up capital of ` 100 lakhs consisting
of 10 lakhs ordinary shares of ` 10 each. Currently, it is earning an annual pre-tax
profit of ` 60 lakhs. The company’s shares are listed and are quoted in the range of `
50 to ` 80. The management wants to diversify production and has approved a
project which will cost ` 50 lakhs and which is expected to yield a pre- tax income of
` 40 lakhs per annum. To raise this additional capital, the following options are
under consideration of the management:
a. To issue equity share capital for the entire additional amount. It is expected that
the new shares (face value of ` 10) can be sold at a premium of ` 15.
b. To issue 16% non-convertible debentures of ` 100 each for the entire amount.
c. To issue equity capital for ` 25 lakhs (face value of ` 10) and 16% non-
convertible debentures for the balance amount. In this case, the company can
issue shares at a premium of ` 40 each.
You are required to advise the management as to how the additional capital
can be raised, keeping in mind that the management wants to maximise the
earnings per share to maintain its goodwill. The company is paying income tax at
50%.

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Question 2

Roman Limited is considering three financing plans. The key information is as

follows:
a. Total investment to be raised ` 2,00,000
b. Plans of Financing Proportion:

Plans Equity Debt Preference Shares

A 100% - -
B 50% 50% -
C 50% - 50%

c. Cost of debt 8%
Cost of preference shares 8%
d. Tax rate 50%
e. Equity shares of the face value of ` 10 each will be issued at a premium of ` 10
per share.
f. Expected EBIT is ` 80,000.
You are required to determine for each plan:
i. Earnings per share (EPS)
ii. The financial break-even point.
iii. Indicate if any of the plans dominate and compute the EBIT range among the
plans for indifference.

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Question 3

MLtd. is foreseeing a growth rate of 12% per annum in the next two years. The
growth rate is likely to be 10% for the third and fourth year. After that the growth
rate is expected to stabilise at 8% per annum. If the last dividend was ` 1.50 per
share and the investor’s required rate of return is 16%, determine the current value
of equity share of the company.
The P.V. factors at 16%
Year 1 2 3 4
P.V. Factor .862 .743 .641 .552

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Question 4

Sun Ltd. is considering two financing plans.

Details of which are as under:
i. Fund's requirement – ` 100 Lakhs
ii. Financial Plan
Plan Equity Debt
I 100% -
II 25% 75%

iii. Cost of debt – 12% p.a.

iv. Tax Rate – 30%
v. Equity Share ` 10 each, issued at a premium of ` 15 per share
vi. Expected Earnings before Interest and Taxes (EBIT) ` 40 Lakhs

You are required to compute:

i. EPS in each of the plan
ii. The Financial Break Even Point
iii. Indifference point between Plan I and II

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Question 5
The following is an extract from the financial statements of Zeta Limited:
Amount (`lakhs)
Operating Profit 105.0
Less: Interest on Debentures 33.0
Earnings before Taxes 72.0
Less: Income Tax (35%) 25.2
Earnings after Taxes 46.8
Equity Share Capital (shares of ` 10 each) 200.0
Reserves and Surplus 100.0
15% Non-Convertible Debentures (of ` 100 each) 220.0
520.0

The market price per equity share is ` 12 and per debenture is ` 93.75.

You are required to calculate:

a. The earnings per share.
b. The percentage cost of capital to the company for debentures and the equity.

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Question 6
M/s. Novio Corporation has a capital structure of 40% debt and 60% equity. The
company is presently considering several alternative investment proposals costing
less than ` 20 lakhs. The corporation always raises the required funds without
disturbing its present debt equity ratio.
The cost of raising the debt and equity are as under:
Project cost Cost of debt Cost of equity
Upto ` 2 lakhs 10% 12%
Above ` 2 lakhs & upto to ` 5 lakhs 11% 13%
Above ` 5 lakhs & upto `10 lakhs 12% 14%
Above `10 lakhs & upto ` 20 lakhs 13% 14.5%
Assuming the tax rate at 50%, calculate:
i. Cost of capital of two projects X and Y whose fund requirements are ` 6.5 lakhs
and ` 14 lakhs respectively?
ii. If a project is expected to give after tax return of 10%, determine under what
conditions it would be acceptable?

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Question 7

The sales of Tesoro Ltd. (LFL) are Rs.20 crore. The variable expenses are 60 percent
of sales and fixed expenses are Rs.4 crore. The long term capital of the company
consists of term loan and debentures. The term loan amounts to Rs.2 crore and the
debentures amount to Rs.3 crore. The term loan carries an interest rate of 10.5% and
the debentures carry an interest rate of 11.5%. The tax rate applicable is 36%.
You are required to answer the following questions:

a. Calculate the degree of operating leverage, degree of financial leverage and

degree of total leverage of the firm at the existing level of operations.
b. The company is planning to expand its operations which will require an
additional investment of Rs.6 crore. After the expansion the sales are expected
to increase by 20 percent and the variable costs to sales ratio will remain
unchanged. The fixed expenses will increase by 25 percent. The entire amount
of additional investment will be financed either by issuing debentures with an
interest rate of 12 percent or by issuing preference shares with a preference
dividend of 12.5percent.

Find out how the company should finance the additional investment on its
expansion programme. Support your answer with necessary calculations and
explanation.

Question 8
Shahji Steels Limited requires Rs.25,00,000 for a new plant. This plant is expected to
yield earnings before interest and taxes of Rs.5,00,000. While deciding about the
financial plan, the company considers the objective of maximizing earnings per
share. It has three alternatives to finance the project - by raising debt of Rs.2,50,000
or Rs.10,00,000 or Rs.15,00,000 and the balance, in each case, by issuing equity
shares. The company's share is currently selling at Rs.150, but is expected to decline
to Rs.125 in case the funds are borrowed in excess of Rs.10,00,000. The funds can be
borrowed at the rate of 10 percent uptoRs.2,50,000, at 15 percent over Rs.2,50,000
and up to Rs.10,00,000 and at 20 percent over Rs.10,00,000. The tax rate applicable to
the company is 50 percent. Which form of financing should the company choose?

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Question 9
Yoyo Limited presently has Rs.36,00,000 in debt outstanding bearing an interest rate
of 10 per cent. It wishes to finance a Rs.40,00,000 expansion programme and is
considering three alternatives: additional debt at 12 per cent interest, preference
shares with an 11 per cent dividend, and the issue of equity shares at Rs.16 per share.
The company presently has 8,00,000 shares outstanding and is in a 40 per cent tax
bracket.
(a) If earnings before interest and taxes are presently Rs.15,00,000, what would be
earnings per share for the three alternatives, assuming no immediate increase in
profitability?
(b) Develop an indifference chart for these alternatives. What are the approximate
indifference points? To check one of these points, what is the indifference point
mathematically between debt and common?
(c) Which alternative do you prefer? How much would EBIT need to increase before
the next alternative would be best?

Question 10
A company requires Rs. 1,500,000 for the installation of a new unit, which would yield
an annual EBIT of Rs. 250,000. The company’s objective is to maximize EPS. It is
considering the possibility of raising a debt of either Rs. 300,000 or Rs. 600,000 or Rs.
900,000 plus issuing equity shares. The current market price per share is Rs. 50 which
is expected to drop to Rs. 40 per share, if the market borrowings were to exceed Rs.
700,000. The cost of borrowings are indicated as follows:
Level of borrowings Cost of borrowings
Up to Rs. 200,000 12%
More than 200,000 to 600,000 15%
More than 600,000 to 900,000 17%
Required:
Assuming the tax rate of 50%, work out the EPS of the scheme, which you would
recommend to the company
Calculate return on capital employed under each scheme and explain the leverage
effect.

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Question 11

X ltd has a share capital of Rs 1, 00,000 divided into shares of Rs 10 each. it has major
expansion programme requiring an investment of another Rs. 50000 the
management is considering the following alternative for raising this amount.
i) Issue of 5000 equity share Rs 10 each.
ii) Issue of 5000, 12% pref. share of Rs 10 each
iii) Issue of 10% debentures of Rs 50000 the Company’s present earnings before
interest and tax (EBIT) are Rs. 40000 p.a. you are required to calculate the effect of
each of the above modes on financing of EPS presuming:
a) EBIT continues to be same even after expansion.
b) EBIT increases by Rs. 10000

Question 12

X Ltd a widely held company is considering a major expansion of its production

facilities and the following alternatives are available:

([Link] lakh)
Alternatives A B C
Share Capital 50 20 10
14% debentures - 20 15
Loan from a financial institution @18% p.a - 10 25

Expected rate of return before tax is 25%. The rate of dividend of the company is
not less than 20%. Which of the alternative you would choose. Corporate taxation
40%.

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Question 13

Calculate the level of earnings before interest and tax (EBIT) at which EPS
indifference point between the following financing alternative will occur.
i) Equity share capital of 600000 & 12% deb. of 400,000
OR
ii) Equity share capital of 400000, 14% pref- share capital of 200000 & 12%
debentures of Rs. 400000.

Assume the corporate tax rate is 35% and Par value of equity share is Rs.
10 in each case.

Question 14

A company needs Rs. 31, 25,000 for the construction of new plant the following
three plans are feasible:
i). The company issue 312500 equity shares at Rs. 10 per share.
ii) The company may issue 156250 equity shares at Rs 10 per share and 15,625
debentures of Rs.100 denomination bearing a 8% rate of interest.
iii) The company may issue 156250 equity shares at Rs 10 and 15,625
cumulative preference share of Rs.100 per share bearing a 8% rate of
dividend

a) If the company's earnings before interest and tax are Rs. 62500, Rs. 125000,
Rs. 250000, Rs.375000 and Rs. 625000 what are the EPS under each of three
alternatives? Assume income tax rate of 40%
b) Which alternative would you recommend & why
c) Determine the EBIT - EPS indifference point between financing plan I &
Plan II and Plan I and Plan II

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Question 15
DFL ltd. plan to expand assets by 60 percent. To finance the expansion, it has a
choice between a straight 9 percent debt and equity issue. Its current balance sheet
and income statement are as shown below:

Balance sheet of DLF [Link] on 32 Asadh

Liabilities Rs. Assets Rs.
Equity capital (Rs. 100 per 25,00,000 Total assets 50,00,000
share)
Retained earnings 15,00,000

5% Debt 10,00,000 50,00,000

50,00,000

Income Statement for the year ended on 32 Ashadh

Particulars Amount
Sales 15,000,000
Less: Total cost (Excluding interest) 13,450,000
EBIT 1,550,000
Less: Interest 50,000
Profit Before Tax 1,500,000
Less: Tax 450,000
Profit After Tax 1,050,000

If the company finances the proposed expansion with debt, the rate on the
incremental debt will be 9 percent and the price/ earning ratio of the equity
shares will be 10. If expansion is financed by equity, the new shares can be sold at
NRs. 300 and the price/earning ratio of all the outstanding equity shares will
remain 12.

Considering all the information given above, you are required to do the
following:
Assuming that net income before interest on debt and taxes (EBIT) is 10 percent
on the sales, calculate EPS at assumed sales of NRs. 10 million, NRs. 20 million,
NRs. 25 million under the alternative mode of financing the expansion program
(assume no fixed costs)

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 Using the price/earning ratio indicated, calculate the market value of equity share
for each sales level for both debt and equity methods of financing.
If the firm follows the policy of seeking to maximize the price of its shares, which
form of financing should be employed?
I. (a) 19.04, 19 (b) 47.04, 39 (c) 61.04, 49
ii.(a) 190.4, 228 (b) 470.4, 468 (c) 610, 588

Question 16

M K Ltd. has appointed you as its finance Manager. The company wants to
implement a project for which Rs. 60 lakhs is required to be raised from the
market as a means of financing the project. The following financial plans and their
options are at hand:
(Rs. in Lakh)
Particular Plan X Plan Y Plan Z
Option 1: Equity Shares 60 60 60
Option 2: Equity shares 30 40 20
13% Preference Shares Nil 20 20
10% Non-Convertible debenture 30 Nil 20
Assume corporate tax rate to be 25 percent, and the face value of all the shares
and debentures to be Rs.100 each.
i) Calculate the indifference points and EPS for each of the financing
plan.
ii) Which plan should be accepted by the company? Why?
Ans: EPS 10, 17.33, 13.67

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Question 17

Shakti Cement Ltd requires Rs .5, 00,000 for construction of a new plant. It is
considering following three alternatives financial plans:
i. The company may issue 50,000 ordinary shares at Rs. 10 per share;
ii. The company may issue 25,000 ordinary shares at Rs. 10 per shares and
2,500 debentures of Rs.100 denominations bearing a 8% rate of interest;
iii. The company may issue 25,000 ordinary shares at Rs. 10 per shares and
2,500 preference shares at Rs. 100 per shares bearing a 8% rate of
dividend.

The possible level of earnings before interest and taxes (EBIT) of shakti Cement
Ltd. are Rs.10,000; Rs.20,000; Rs.40,000; Rs. 60,000 and Rs. 1,00,000. The
applicable tax rate is 25%.
Required
I. Compute the earnings per share under each of the three financial plans and
different levels of EBIT.
II. Which alternatives would you recommend for the company and why?

Question 18
A company earns a profits of Rs. 3, 00,000 per annum after meeting its interest
liability of Rs, 1, 20,000 on 12% debentures. The Tax rate is 50%. The number of
equity shares of Rs. 10 each are 80,000 and the retained earnings amount to Rs. 12,
00,000. The company proposes to take up an expansion scheme for which a sum of
Rs. 4, 00,000 is required. It is anticipated that after expansion, the company will be
able to achieve the same return on investment as at present. The funds required for
expansion can be raised either through debt at the rate of 12% or by issuing equity
Shares at par.
Required
i) Compute the Earnings per share (EPS), if:
 The additional funds were raised as debt
 The additional funds were raised by issue of equity shares.
ii) Advice the company as to which source of finance is preferable.
(Ans: EPS- 1.875, 1.925, 1.48)

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Question 19
The net sales of M Ltd. is Rs.30 crores. Earnings before interest and tax of the
company as a percentage of net sales is 12%. The capital employed comprises Rs. 10
crores of equity, Rs. 2 crores of 13% Cumulative Preference Share Capital and 15%
debentures of Rs. 6 crores. Income-tax rate is 40%.
(i) Calculate the Return-on-equity for the company and indicate its segments
due to the Presence of preference Share Capital and Borrowing
(debentures).
(ii) Calculate the Operating Leverage of the company given that combined
leverage is

Question 20
The following figures are made available to you:

Amount ( Rs.)
Net profits for the year 18,00,000
Less: Interest on secured debentures at 15% p.a. 1,12,500
(Debentures were issued 3 months after the 16,87,500
commencement of the year)
Less: Income-tax at 35% and dividend distribution tax 8,43,750
Profit after tax 8,43,750
Number of equity shares (Rs.10 each)
1,00,000
Market quotation of equity share
Rs. 109.7

The company has accumulated revenue reserves of Rs. 12 lakhs. The company is
examining a project calling for an investment obligation of Rs.10 lakhs; this
investment is expected to earn the same rate of return as funds already employed.
You are informed that a debt equity ratio (debt Divided by debt plus equity) higher
than 60% will cause the price earnings ratio to come down by 25% and the interest
rate on additional borrowals will cost company 300 basis points more than on the
current borrowals on secured debentures.
You are required to advise the company on the probable price of the equity shares, if
The additional investment were to be raised by way of loans; or
The additional investment were to be raised by way of equity.
(Ans: 132.10, 130.70)

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 Question 21
Z Ltd. is considering the following two alternative financing plans:

Plan-I Plan-II
Rs. Rs.
Equity shares of 10 each 4,00,000 4,00,000
12% Debentures 2,00,000 ----
Preference Shares of 100 each ---- 2,00,000
6,00,000 6,00,000

The indifference points between the plans is Rs 2, 40,000. Corporate tax rate is 30%.
Calculate the rate of dividend on preference shares. (Ans: 8.4%)
Question 22
A company requires capital funds of Rs. 5 crores and has two options: (i) To raise
the amount by the issue of 15% debentures, and (ii) To issue equity shares at a rate
of Rs. 20 per share. It already has 40 lacs equity shares issued and debt financing of
Rs.6 crores at the rate of 12%. Find out the expected EPS under both financing
options at the given EBIT levels of Rs. 2 crores and Rs.7.5 crores. What should be
choice of the company given that the applicable tax rate is 50%?
Ans. Debt Financing (EPS Rs.0.67 and Rs.7.54), Equity financing (Rs. 0.98 and
Rs.5.22)

Question 23
West Nepal Industries Ltd. is a profit-making company with a paid up capital of
Rs.100 Lacs consisting of 10 Lacs ordinary shares of Rs. 10 each. Currently, it is
earning an annual EBIT profit of Rs. 60 Lacs. The management wants to diversify
production and has approved a project which will cost Rs. 50 Lacs and which is
expected to yield income of Rs. 40 Lacs per annum. to raise this additional capital,
the following options are under consideration of the management:
(a) To issue equity capital for the entire additional amount. It is expected that
new shares (face value of Rs.10) can be sold at a premium of Rs. 15.
(b) To issue 16% Non- convertible debentures of Rs.100 each for the entire
amount.
(c) To issue equity capital for Rs. 25, 00,000 (face value of Rs.10) and 16% Non-
convertible debentures for the balance amount. In this case, the company can
issue shares at a premium of Rs.40 each.

The management wants to maximize the earning per share. The company is
paying income-tax at 50%. Advise the management as to how the additional
capital can be raised. Shows workings. (Ans: EPS Rs.4.17, Rs. 4.60 and Rs. 4.57)
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Question 24
Paramount products Ltd. wants to raise Rs 100 Lacs for a diversification project.
Current estimates of Earnings before Interest and Taxes (EBIT) firm the new
projects is Rs. 22 Lacs per annum. Cost of debt will be 15% for amounts up to and
including Rs.40 Lacs, 16% for additional amounts up to and including Rs. 50 Lacs
and 18% for additional amounts above Rs.50 Lacs.
The equity shares (face value Rs.10) of the company have a current market value of
Rs.40. this is expected to fall to Rs.32 if debts exceeding Rs.50 Lacs are raised.
The following options are under consideration of the company:
Option Equity Debt
I 50% 50%
II 60% 40%
III 40% 60%
Determine the Earnings per share (EPS), for each option and state which option the
company should exercise. Tax rate applicable to the Company is 50%.

(Ans: EPS Rs.5.76, 5.33 and Rs.5.04)

Question 25
A company desires to take up a capital project under its expansion programme
involving an outlay or investment of Rs. 10, 00,000. If it is financed through issue
of debentures carrying 14% interest rate, the price earning ratio will be 6 times.
However, if it is financed through equity capital issued at a premium of Rs. 15,
then the price earnings ratio is to be 7 times. This expansion programme is likely to
enhance firm's sales by 6, 00,000 a year. The amount of EBIT is to increase by Rs.
90,000.
Firm's current financial position is given as below:

Particulars Amount
Total debenture@10% 400,000
Equity Share Capital (Rs.10 each) 1,000,000
Retained Earnings 600,000
Total Capital Employed 2,000,000

Particulars Amount
Present Sales 6,000,000
Less: Total expenses/ costs 5,360,000
EBIT 640,000
Less: Interest 40,000
Profit Before Tax 600,000
Less: Tax@40% 240,000
Profit After Tax 360,000

Calculate market value of shares in each case. (Ans: Rs.19.80 and Rs 20.70)
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Question 26
Indra Ltd. has EBIT of Rs.1,00,000 . The company makes use of debt and equity
capital. The firm has 10% debentures of Rs.5,00,000 and the firm’s equity
capitalization rate is 15%.
You are required to compute:
(i) Current value of the firm
(ii) Overall cost of capital.

Question 27
Amita Ltd’s operating income is Rs.5,00,000. The firm’s cost of debt is 10% and
currently the firm employs Rs.15,00,000 of debt. The overall cost of capital of the
firm is 15%.
You are required to determine:
(i) Total value of the firm.
(ii) Cost of equity.

Question 28
Alpha Limited and Beta Limited are identical except for capital structures. Alpha
Ltd. has 50 per cent debt and 50 per cent equity, whereas Beta Ltd. has 20 per cent
debt and 80 per cent equity. (All percentages are in market-value terms). The
borrowing rate for both companies is 8 per cent in a no-tax world, and capital
markets are assumed to be perfect.
(a) (i) If you own 2 per cent of the shares of Alpha Ltd., what is your return if
the company
has net operating income of Rs. 3,60,000 and the overall capitalization rate of
the
company, K0 is 18 per cent? (ii) What is the implied required rate of return on
equity?

(b) Beta Ltd. has the same net operating income as Alpha Ltd. (i) What is the
implied
Required equity return of Beta Ltd.? (ii) Why does it differ from that of Alpha
Ltd.?

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 Question 29
One-third of the total market value of Sanghmani Limited consists of loan stock,
which has a cost of 10 per cent. Another company, Samsui Limited, is identical in
every respect to Sanghmani Limited, except that its capital structure is all-equity,
and its cost of equity is 16 per cent. According to Modigliani and Miller, if we
ignored taxation and tax relief on debt capital, what would be the cost of equity
of Sanghmani Limited?

Question 30
There are two firms P and Q which are identical except P does not use any debt
in its capital structure while Q has `8,00,000, 9% debentures in its capital
structure. Both the firms have earnings before interest and tax of ` 2,60,000 p.a.
and the capitalization rate is 10%. Assuming the corporate tax of 30%, calculate
the value of these firms according to MM Hypothesis.

Question 31

'A' Ltd. and 'B' Ltd. are identical in every respect except capital structure. 'A' Ltd.
does not employ debts in its capital structure whereas 'B' Ltd. employs 12%
Debentures amounting to Rs. 10 lakhs. Assuming that :
(i) All assumptions of M-M model are met;
(ii) Income-tax rate is 30%;
(iii) EBIT is ` 2,50,000 and
(iv) The Equity capitalization rate of ‘A' Ltd. is 20%.
Calculate the value of both the companies and also find out the Weighted
Average Cost of Capital for both the companies.

Question 32
Stopgo ltd, an all equity financed company is considering the repurchase of Rs.
200 lakhs equity & to replace it with 15% debenture of the same amount. Current
market value of the company is Rs. 1140 lakhs & its cost of capital is 20%. It's
Earnings before interest & taxes (EBIT) are expected to remains constant in future.
It's entire earnings are distributed as dividend. Applicable tax rate is 30%.
You are required to calculate the impact on the following on account of the change
in capital structure as per Modigliani and Miller ( MM) Hypothesis.

I. The market value of the company

II. It's cost of capital, and
III. It's cost of equity

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Question 33: (ICAN SM-Example -5 Page-45)

The Balance sheet of Smart ltd. as on Asadh 31, 2077 is as follows:

Capital/Liabilities Rs."In Lakh" Assets Rs."In Lakh"

Fixed
200 500
Share Capital Assets
Reserves 140 Inventories 300
Long term Loans 360 Receivables 240
Cash &
200 60
Short term loans Bank
Payables 120
Provisions 80
1100 1100

Sales for the year were Rs.600 lakhs. For the year ending Asadh 31, 2078 sales are
expected to increase by 20%. The Profit margin and dividend payout ratio are
expected to be 4% & 50% respectively.
You are required to :
I. Quantify the amount of external funds required
II. Determine the mode of raising funds given the following parameters:
a. Current ratio should at least be 1.33.
b. Ratio of fixed assets to long term loans should be 1.5
c. Long term debt to equity ratio should not exceed 1.05
d. The fund are to be raised in the order of short term bank borrowings, long
term loan & Equities.

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