PRACTICE QUESTIONS AND ANSWER - CAPITAL STRUCTURE

 

PROBLEMS ON CAPITAL STRUCTURE

Problem:1 A company needs Rs.6,00,000 for construction of a new plant. The following three financial plans are feasible.

1)      The company may issue 60,000 equity shares of Rs.10 each.

2)      The company may issue 30,000 equity shares of Rsf. 10 each and 3000 debentures of Rs. 100 each bearing 8% coupon rate of interest.

3)      The company may issue 30,000 equity shares of Rs. 10 each and 3000 preference shares of Rs. 100 each bearing 8% coupon rate of interest.

Earnings before interest and taxes (EBIT) are expected to be Rs.1, 50,000. Corporate tax is 50%.

Calculate the earnings per share (EPS) under three plans. Which plan would you recommend and why?

Problem:2 Alpha company  Ltd., has an all equity capital structure consisting of 20,000 equity shares of Rs.100 each. The management plans to raise Rs.30 lakhs to finance a program of expansion.

Three alternative methods of financing are under consideration.

1)      The company may issue 30,000 equity shares of Rs.100 each.

2)      Issue of 30,000, 8% debenture of Rs. 100 each

3)      Issue of 30,000 8%preference shares of Rs. 100

Earnings before interest and taxes(EBIT) is expected to be Rs.10,00,000. Corporate tax is 50%.

Calculate the earnings per share (EPS) under three plans. Which plan would you recommend and why?

Problem:3 Ace Ltd., has a share capital of Rs.1,00,000 divided into shares of Rs.10 each. The management is considering the following alternatives for financing a capital expenditure of Rs.50, 000.

1.      Issue of 10% debentures.

2.      Issue of 5,000, 12% preference shares of Rs.10 each.

3.      Issue of 5,000 shares of Rs.10 each.

Calculate the effect of each alternatives on the earnings per share (EPS), assuming

a)      EBIT continues to be same even after capital expenditure

b)      EBIT increases by Rs.15,000

c)      Tax liability is 40%.

Problem:4 Anand Ltd., is capitalised with Rs.10 lakhs, divided into 10,000 shares of Rs.100 each. The management decides to raise another Rs.10 lakh to finance an expansion plan. There are four alternatives.

1.      All equity shares.

2.      Equity shares for Rs. 5 lakhs and 5% debentures of Rs. 5 lakh.

3.      All debentures carrying 6% interest.

4.      Equity shares of Rs.5, 00,000 and 5% preference shares of Rs.5, 00,000.

You are required to calculate the earnings per share (EPS) under each of the above plan if the expected earnings before interest and taxes is

a)      Rs.1,20,000

b)      Rs.2,40,000

Assume a tax rate is 40%.

Problem: 5 Lucky Star Ltd., has 10,000 equity shares outstanding. The company is considering conversion of 500 14% bonds of Rs.1, 000 each into equity shares. Each bond is convertible into 8 shares. The price earnings ratio before and after conversion is expected to be 20 and 22 respectively.

The current EBIT is Rs.2, 00,000. Corporate tax is 40%. Is it advisable to convert to bonds?

Theories of Capital Structure

Net Income (NI) Approach

Problem:6 Bharathi Ltd., expects an annual return EBIT of Rs.1,00,000.The company has Rs.4,00,000 in 10% debentures. The Equity Capitalisation rate is 12.5%. The company proposes to issue additional equity shares of Rs.1, 00,000 and use the proceeds for redemption of debentures of Rs.1, 00,000. Calculate the value of the firm and the overall cost of capital.

Problem:7 A company Expects a net operating income of Rs.1,00,000.The equity capitalisation rate of the company is 10%. It has Rs.5,00,000  6%debentures. Calculate the value of the firm and overall capitalisation rate according to Net Income Approach(ignore tax)

b)if the firm’s debentures are increased to Rs.7,00,000, what shall be the value of the firm and overall capitalisation rate? Give your comments.

Net Operating Income (NOI) Approach.

Problem:8 A Ltd., expects a net operating income of Rs.1,20,000. It has Rs.6, 00, 000, 6% debentures. The overall capitalisation rate is 10%.Calculate the value of the firm and cost of equity according to Net Operating Income (NOI) approach. b) What will the value of the firm and cost of equity if the debenture debts are increased to Rs.9, 00,000?

POINT OF INDIFFERENCES

Problem: 6 A new project requires an investment of Rs.600 lakhs. Two alternative methods of financing are under consideration.

1.      Issue of equity shares of Rs.10 each for Rs.600 lakhs.

2.      Issue of equity shares of Rs.10 each for 400 lakhs and issue of 15% debentures of Rs.200 lakhs.

Find out the indifference level of EBIT assuming a tax rate of 40%. Verify your answer.

LEVERAGES

Moon Ltd., and Star Ltd., have provided you with the following informations.

           

 

Moon Ltd.,

Star Ltd.,

Sales (in units)

Price per unit

Variable cost per unit

Fixed operating cost

Fixed financing cost

20,000

Rs.50

Rs.20

Rs.4,00,000

Rs.1,00,000

20,000

Rs.50

Rs.25

Rs.3,00,000

Rs.50,000

Calculate

a)      Operating Leverage

b)      Financial leverage

c)      Combined leverage

Also  compare and comment.

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