CA INTER FM ECO

CHAPTER 5

Capital Structure
- CA Mayank Kothari

40
44

Theory Questions Numericals

CA Inter FM-ECO CA Mayank Kothari

Chapter 5
Financing Decisions-Capital Structure
1. Explain the meaning of the term “Capital Structure”.
Answer:
Capital structure is the combination of capitals from different sources of
finance, primarily consisting of equity share holders’ fund, preference
share capital and long term external debts.
The source and quantum of capital is decided on the basis of need of the
company and the cost of the capital.
However, the prime objective of a company is to maximize the value of
the company while deciding the optimal capital structure.

2. How do we calculate value of a firm?

Answer:
The value of firm is calculated as below:
EBIT
Value of the firm
! =
Overall cost of capital or Weighted average cost of capital

! 0 = (Cost of debt × weight of debt) + (Cost of equity × weight of equity)

K

! 0 = [{K d × D/(D + S)} + {K e × S/(D + S)}]

K

Where,
K
! 0 = Weighted average cost of capital
K
! d = Cost of Debt
D = Market value of debt
S = Market value of equity
K
! e = Cost of equity

Page 1 of 55
CA Inter FM-ECO CA Mayank Kothari

3. What do you mean by capital structure decision? How is it relevant in

maximizing the value of the firm and minimizing overall cost of capital?
Answer:
Capital Structure decision refers to deciding the sources of financing, the
amount to be funded and their relative proportions (mix) in total
capitalization.
Whenever funds are to be raised to finance investments, capital structure
decision is involved.
It helps in deciding weight of debt and equity and ultimately overall cost
of capital as well as Value of the firm.
So ultimately, capital structure is relevant in maximizing value of the
firm and minimizing overall cost of capital.

4. There are different approaches taken to explain the relationship between

cost of capital, capital structure and value of the firm. Depict those
approaches.
Answer:
The following are the different approaches:

Net Income Approach

CS Relevance
Theories

Traditional Approach

Capital Structure
Theories

Net Operating Income

Approach

CS Irrelevance Theory

Modigliani Miller
Approach

Page 2 of 55
CA Inter FM-ECO CA Mayank Kothari

1. Net Income (NI) Approach

2. Traditional Approach
3. Net Operating Income (NOI) Approach
4. Modigilani-Miller (MM) Approach

5. To understand the relationship between cost of capital, capital structure

and value of the firm, a number of assumptions are taken. Mention those
assumptions.
Answer:
The assumptions taken while understanding the relationship are mentioned as
below:
There are only two kinds of funds used by a firm i.e. debt and equity.
The total assets of the firm are given. The degree of average can be
changed by selling debt to purchase shares or selling shares to retire
debt.
Taxes are not considered.
The payout ratio is 100%.
The firm’s total financing remains constant.
Business risk is constant over time.
The firm has perpetual life.

6. As per the Net Income (NI) Approach, explain how the capital structure
decision affects weighted average cost of capital (WACC) thereby affecting
the value of the firm as well as market price of shares.
Answer:
Capital structure decision primarily helps in deciding weight of debt and
equity and ultimately overall cost of capital as well as Value of the firm
& the market price of shares.
An increase in financial leverage will lead to decline in the weighted
average cost of capital (WACC), while the value of the firm as well as
market price of ordinary share will increase.
Conversely, a decrease in the leverage will cause an increase in the
overall cost of capital and a consequent decline in the value as well as
market price of equity shares. Thus as debt increases, WACC decreases.
Thus, under the NI approach, the value of the firm & market price of
shares will be maximum when WACC is minimum.

Page 3 of 55
CA Inter FM-ECO CA Mayank Kothari

On point to remember is that in both the above situation, it is assumed

that !K e and K
! d do not change with leverage.

7. How under the Net Income approach (NI), the firm can increase its total
value?
Answer:
Under the NI approach, the value of the firm & market price of shares
will be maximum when WACC is minimum.
Thus according to this approach, the firm can increase its total value by
decreasing its overall cost of capital through increasing the degree of
leverage.
Thus, to achieve highest market price of shares and highest value of the
firm, total or maximum possible debt financing should be done to
minimize the cost of capital.
The significant conclusion of this approach is that it pleads for the firm
to employ as much debt as possible to maximize its value.

8. How do we calculate the value of the firm on the basis of Net Income (NI)
Approach?
Answer:
The value of the firm on the basis of Net Income (NI) Approach is given by,
! Value of the firm(V) =S+D
Where,
V = Value of the firm
S = Market value of equity
D = Market value of debt

9. Provide how market value of equity is calculated.

Answer:
The market value of equity is calculated as below:
NI
! Market value of equity (S) =
Ke
Where,
NI = Earnings available for equity shareholders
K
! e= Equity Capitalization rate

Page 4 of 55
CA Inter FM-ECO CA Mayank Kothari

10.How will you calculate overall cost of capital under Net Income (NI)
Approach?
Answer:
The overall cost of capital under this approach is :
EBIT
! Overall cost of capital =
Value of the firm
Thus according to this approach, the firm can increase its total value by
decreasing its overall cost of capital through increasing the degree of
leverage.
The significant conclusion of this approach is that it pleads for the firm
to employ as much debt as possible to maximize its value.

11.Explain traditional approach used to explain the capital structure theory

(that is, the relationship between cost of capital, capital structure and value
of the firm). Also explain with reference to the traditional approach where
optimal capital structure is obtained?
Answer:
Traditional approach favors that as a result of financial leverage up to
some point, cost of capital comes down and value of firm increases.
However, beyond that point, reverse trends emerge.
Under this approach it is believed that there is an optimal capital
structure which minimizes the cost of capital.
At the optimal capital structure, the real marginal cost of debt and
equity is the same.
Before the optimal point, the real marginal cost of debt is less than real
marginal cost of equity and beyond this optimal point the real marginal
cost of debt is more than real marginal cost of equity.
Optimum capital structure occurs at the point where value of the firm
is highest and the cost of capital is the lowest.

Page 5 of 55
CA Inter FM-ECO CA Mayank Kothari

12.Explain treatment of capital structure decisions under different approaches

used to explain capital structure theory.
Answer:
As per the Net Income approach capital structure decision primarily
helps in deciding weight of debt and equity and ultimately decides
overall cost of capital as well as Value of the firm & the market price
of shares.
However, according to net operating income approach, capital
structure decisions are totally irrelevant.
Modigliani-Miller supports the net operating income approach but
provides behavioral justification.
The traditional approach, on the other hand strikes a balance between
Net operating income approach and Modigliani-Miller approach (that
is, between extremes).

13.What according to you are the main highlights of traditional approach?

Answer:
The main highlights of traditional approach are mentioned as below:
a) Capital Structure:
The firm should strive to reach the optimal capital structure and its
total valuation through a judicious use of the both debt and equity
in capital structure.
At the optimal capital structure, the overall cost of capital will be
minimum and the value of the firm will be maximum.
b) Financial Leverage:
Value of the firm increases with financial leverage up to a certain
point.
Beyond this point the increase in financial leverage will increase its
overall cost of capital and hence the value of firm will decline.
This is because the benefits of use of debt may be so large that even
after offsetting the effect of increase in cost of equity, the overall
cost of capital may still go down.
However, if financial leverage increases beyond an acceptable limit,
the risk of debt investor may also increase, consequently cost of
debt also starts increasing.

Page 6 of 55
CA Inter FM-ECO CA Mayank Kothari

The increasing cost of equity owing to increased financial risk and

increasing cost of debt makes the overall cost of capital to increase.

14.Explain Net operating Income approach (NOI)?

Answer:
Net operating Income means earnings before interest and tax (EBIT).
According to this approach, capital structure decisions of the firm are
irrelevant.
Any change in the leverage will not lead to any change in the total
value of the firm and the market price of shares, as the overall cost of
capital is independent of the degree of leverage.
As a result, the division between debt and equity is irrelevant.
As per this approach, an increase in the use of debt which is apparently
cheaper is offset by an increase in the equity capitalization rate.
This happens because equity investors seek higher compensation as
they are opposed to greater risk due to the existence of fixed return
securities in the capital structure.

15.Explain how Modigliani-Miller approach (MM) is different from Net

operating Income approach (NOI)? Also mention how Modigliani-Miller
approach is classified.
Answer:
The NOI approach is conceptual and lacks behavioral significance. It
does not provide operational justification for irrelevance of capital
structure.
However, Modigliani-Miller’s approach provides behavioral
justification for constant overall cost of capital and therefore, totals
value of the firm.
Modigliani-Miller approach can be classified as below:
A. MM approach-1958 : without tax
B. MM approach-1963 : with tax

Page 7 of 55
CA Inter FM-ECO CA Mayank Kothari

16.Briefly explain “MM approach-1958: without tax”. Also mention

assumptions considered under this approach.
Answer:
This approach describes that in a perfect capital market where there is
no transaction cost and no taxes, the value and cost of capital of a
company remain unchanged irrespective of change in the capital
structure.
The approach is based on further additional assumptions like:
1. Capital markets are perfect. All information is freely available and
there are no transaction costs.
2. All investors are rational.
3. Firms can be grouped into ‘Equivalent risk classes’ on the basis of
their business risk.
4. Non-existence of corporate taxes.

17.Briefly mention the propositions derived based on the assumptions under

Modigliani-Miller approach.
Answer:
The following propositions have been derived based on the assumptions under
Modigliani-Miller approach:
i. Total market value of a firm is equal to its expected net operating
income divided by the discount rate appropriate to its risk class
decided by the market.
! Value of levered firm (Vg) = Value of unlevered firm(Vu)

Net Operating Income (NOI)
Value ofa firm
! =
K0
ii. A firm having debt in capital structure has higher cost of equity than
an unlevered firm. The cost of equity will include risk premium for
the financial risk. The cost of equity in a levered firm is determined as
under:
Debt
K
! e = K 0 + (K 0 − K d )
Equity

Page 8 of 55
CA Inter FM-ECO CA Mayank Kothari

iii.The structure of the capital (financial leverage) does not affect the
overall cost of capital. The cost of capital is only affected by the
business risk.

18.Explain the operational justification of Modigliani-Miller approach.

Answer:
The operational justification of Modigliani-Miller hypothesis is
explained through the functioning of the arbitrage process and
substitution of corporate leverage by personal leverage.
Arbitrage refers to buying asset or security at lower price in one market
and selling it at a higher price in another market. As a result,
equilibrium is attained in different markets.
This is illustrated by taking two identical firms of which one has debt
in the capital structure while the other does not.
Investors of the firm whose value is higher will sell their shares and
instead buy the shares of the firm whose value is lower.
They will be able to earn the same return at lower outlay with the same
perceived risk or lower risk. They would, therefore, be better off.
The value of the levered firm can neither be greater nor lower than that
of an unlevered firm according this approach.
The two must be equal. There is neither advantage nor disadvantage in
using debt in the firm’s capital structure.
No matter how the capital structure of a firm is divided (among debt,
equity etc.), there is a conservation of investment value.
Since the total investment value of a corporation depends upon its
underlying profitability and risk, it is invariant with respect to relative
changes in the firm’s financial capitalization.
According to MM, since the sum of the parts must equal the whole,
therefore, regardless of the financing mix, the total value of the firm
stays the same.

Page 9 of 55
CA Inter FM-ECO CA Mayank Kothari

19.Explain the shortcomings of Modigliani-Miller approach.

Answer:
The main shortcoming of this approach is that the arbitrage process as suggested
by Modigliani-Miller will fail to work because of:
a) Imperfections in capital market,
b) Existence of transaction cost and
c) Presence of corporate income taxes.

20.Briefly explain the MM approach-1963: with tax.

Answer:
In 1963, MM model was amended by incorporating tax.
They recognized that the value of the firm will increase or cost of
capital will decrease where corporate taxes exist.
As a result, there will be some difference in the earnings of equity and
debt-holders in levered and unlevered firm and value of levered firm
will be greater than the value of unlevered firm by an amount equal to
amount of debt multiplied by corporate tax rate.
MM has developed the following formulae for computation of cost of
capital (!KO), cost of equity (!Ke) for the levered firm.

1. !Value of levered company = Value of unlevered company + Tax benefit

Or,
!Vg = Vu + TB
Debt
2. !Cost of equity in a levered firm(K eg) = K eu + (K eu − K d )
Debt + Equity
Where,
K
! eg= Cost of equity in a levered company
!K eu= Cost of equity in an unlevered company
!K d = Cost of debt
t = Tax rate

WACC in a levered company
! 3. (K og) = K eu(1 − tL)
Where,
K
! og= WACC of levered company

Page 10 of 55
CA Inter FM-ECO CA Mayank Kothari

!K eu= Cost of equity in an unlevered company

!T = Tax Rate
Debt
!L    =
Debt + Equity

21.Briefly explain the trade-off theory of capital structure as per Modigliani-

Miller approach?
Answer:
The trade-off theory of capital structure refers to the idea that a
company chooses how much debt finance and how much equity
finance to use by balancing the costs and benefits.
An important purpose of the trade-off theory of capital structure is to
explain the fact that corporations usually are financed partly with debt
and partly with equity.
It states that there is an advantage to financing with debt, the tax
benefits of debt and there is a cost of financing with debt, the costs of
financial distress including bankruptcy costs of debt and non-
bankruptcy costs (e.g. staff leaving, suppliers demanding
disadvantageous payment terms, bondholder/stockholder infighting,
etc.).
The marginal benefit of further increases in debt declines as debt
increases, while the marginal cost increases, so that a firm that is
optimizing its overall value will focus on this trade-off when choosing
how much debt and equity to use for financing.
According to Modigliani and Miller, the attractiveness of debt
decreases with the personal tax on the interest income.

Page 11 of 55
CA Inter FM-ECO CA Mayank Kothari

22.Briefly explain the different concepts that the trade-off theory of capital
structure primarily deals with.
Answer:
Trade-off theory of capital structure primarily deals with the two concepts - cost of
financial distress and agency costs.
A. Financial Distress cost or Bankruptcy cost of debt:
A firm experiences financial distress when the firm is unable to
cope with the debt holders’ obligations.
If the firm continues to fail in making payments to the debt
holders, the firm can even be insolvent.
The direct cost of financial distress refers to the cost of insolvency
of a company.
Once the proceedings of insolvency start, the assets of the firm
may have to be sold at distress price, which is generally much
lower than the current values of the assets.
Also a huge amount of administrative and legal costs is also
associated with the insolvency.
Even if the company is not insolvent, the financial distress of the
company may include a number of indirect costs like – cost of
employees, cost of customers, cost of suppliers, cost of investors,
cost of managers and cost of shareholders.
B. Agency Cost:
The firms may often experience a dispute of interests among the
management of the firm, debt holders and shareholders.
These disputes generally give birth to agency problems that in
turn give rise to the agency costs.
The agency costs may affect the capital structure of a firm.
There may be two types of conflicts - shareholders-managers
conflict and shareholders- debt-holders conflict.

Page 12 of 55
CA Inter FM-ECO CA Mayank Kothari

23.Briefly explain the concept of Pecking Order theory.

Answer:
This theory is based on Asymmetric information, which refers to a
situation in which different parties have different information.
In a firm, managers will have better information than investors.
This theory states that firms prefer to issue debt when they are positive
about future earnings. Equity is issued when they are doubtful and
internal finance is insufficient.
The pecking order theory argues that the capital structure decision is
affected by manager’s choice of a source of capital that gives higher
priority to sources that reveal the least amount of information.
The name ‘PECKING ORDER’ theory is given as there is no well-
defined debt equity target and there are two kind of equity internal and
external.
Pecking order theory suggests that managers may use various sources
for raising fund in the following order.
1. Managers first choice is to use internal finance
2. In absence of internal finance they can use secured debt,
unsecured debt, hybrid debt etc.
3. Managers may issue new equity shares as a last option.
So briefly under this theory rules are
Rule 1: Use internal financing first.
Rule 2: Issue debt next
Rule 3: Issue of new equity shares at last

24.Mention the different sources from which a firm can choose to raise funds.
Answer:
A firm has the choice to raise funds for financing its investment proposals from
different sources in different proportions. They are mentioned as below:
a) Exclusively use debt (in case of existing company), or
b) Exclusively use equity capital, or
c) Exclusively use preference share capital (in case of existing company),
or
d) Use a combination of debt and equity in different proportions, or
e) Use a combination of debt, equity and preference capital in different
proportions, or

Page 13 of 55
CA Inter FM-ECO CA Mayank Kothari

f) Use a combination of debt and preference capital in different

proportion (in case of existing company).

Note: The choice of the combination of these sources is called capital structure
mix.

25.While choosing a suitable financing pattern, certain fundamental

principles should be kept in minds, to design capital structure. Mention and
briefly explain those fundamental principles.
Answer:
The fundamental principles have been explained below:
1. Financial leverage of Trading on Equity:
The use of long-term fixed interest bearing debt and preference
share capital along with equity share capital is called financial
leverage or trading on equity.
The use of long-term debt increases the earnings per share if the
firm yields a return higher than the cost of debt.
The earnings per share also increase with the use of preference
share capital but due to the fact that interest is allowed to be
deducted while computing tax, the leverage impact of debt is
much more.
However, leverage can operate adversely also if the rate of interest
on long-term loan is more than the expected rate of earnings of the
firm.
Therefore, it needs caution to plan the capital structure of a firm.
2. Growth and stability of sales:
The capital structure of a firm is highly influenced by the growth
and stability of its sale.
If the sales of a firm are expected to remain fairly stable, it can
raise a higher level of debt.
Similarly, the rate of the growth in sales also affects the capital
structure decision.
Usually, greater the rate of growth of sales, greater can be the use
of debt in the financing of firm.

Page 14 of 55
CA Inter FM-ECO CA Mayank Kothari

On the other hand, if the sales of a firm are highly fluctuating or

declining, it should not employ, as far as possible, debt financing
in its capital structure.
3. Cost Principle:
According to this principle, an ideal pattern or capital structure is
one that minimizes cost of capital structure and maximizes
earnings per share (EPS).
For e.g. Debt capital is cheaper than equity capital from the point
of its cost and interest being deductible for income tax purpose,
whereas no such deduction is allowed for dividends.
4. Risk Principle:
According to this principle, reliance is placed more on common
equity for financing capital requirements than excessive use of
debt.
Use of more and more debt means higher commitment in form of
interest payout.
This would lead to erosion of shareholders’ value in unfavorable
business situation.
There are two risks associated with this principle:
i. Business risk:
➢ It is an unavoidable risk because of the environment in
which the firm has to operate and it is represented by
the variability of earnings before interest and tax
(EBIT).
➢ The variability in turn is influenced by revenues and
expenses.
➢ Revenues and expenses are affected by demand of firm
products, variations in prices and proportion of fixed
cost in total cost.
ii. Financial risk:
➢ It is a risk associated with the availability of earnings
per share caused by use of financial leverage.
➢ It is the additional risk borne by the shareholders when
a firm uses debt in addition to equity financing.
➢ Generally, a firm should neither be exposed to high
degree of business risk and low degree of financial risk

Page 15 of 55
CA Inter FM-ECO CA Mayank Kothari

or vice-versa, so that shareholders do not bear a higher

risk.
5. Control Principle:
While designing a capital structure, the finance manager may also
keep in mind that existing management control and ownership
remains undisturbed.
Issue of new equity will dilute existing control pattern and also it
involves higher cost.
Issue of more debt causes no dilution in control, but causes a
higher degree of financial risk.
6. Flexibility Principle:
By flexibility it means that the management chooses such a
combination of sources of financing which it finds easier to adjust
according to changes in need of funds in future too.
While debt could be interchanged (If the company is loaded with
a debt of 18% and funds are available at 15%, it can return old
debt with new debt, at a lesser interest rate), but the same option
may not be available in case of equity investment.
7. Other Consideration:
Besides above principles, other factors such as nature of industry,
timing of issue and competition in the industry should also be
considered.
Industries facing severe competition also resort to more equity
than debt.

26.Briefly explain the key concepts for designing optimal structure.

Answer:
The capital structure decisions influence debt–equity mix which
ultimately affects shareholder’s return and risk.
Since cost of debt is cheaper, firm prefers to borrow rather than to raise
money from equity. So long as return on investment is more than the
cost of borrowing, extra borrowing increases the earnings per share.
However, beyond a limit, it increases the risk and share price may fall
because shareholders may assume that their investment is associated
with more risk.

Page 16 of 55
CA Inter FM-ECO CA Mayank Kothari

The major key concepts for designing optimal structure is explained as

below:
a. Leverages:
There are two leverages associated with the study of capital
structure, namely operating leverage and financial leverage.
However, the determination of optimal level of debt is a
formidable task and is a major policy decision which
involves equalizing between return and risk.
EBIT-EPS analysis is a widely used tool to determine level of
debt in a firm.
Through this analysis, a comparison can be drawn for various
methods of financing by obtaining indifference point.
It is a point to the EBIT level at which EPS remains
unchanged irrespective of level of debt-equity mix.
b. Coverage Ratio:
The ability of the firm to use debt in the capital structure can
also be judged in terms of coverage ratio namely EBIT/
Interest.
Higher the ratio, greater is the certainty of meeting interest
payments.
c. Cash flow Analysis:
To determine the debt capacity, cash flow under adverse
conditions should be examined.
A high debt equity ratio is not risky if the company has the
ability to generate cash flows.
It would, therefore, be possible to increase the debt until cash
flows equal the risk set out by debt.
The main drawback of this approach is that it fails to take
into account uncertainty due to technological developments
or changes in political climate.
Note:
These approaches as discussed above do not provide solution to the
problem of determining an appropriate level of debt.
However, with the information available a range can be determined for
an optimum level of debt in the capital structure.

Page 17 of 55
CA Inter FM-ECO CA Mayank Kothari

27.Mention the essential features of a sound capital mix.

Answer:
A sound or an appropriate capital structure should have the following essential
features:
a. Maximum possible use of leverage.
b. The capital structure should be flexible.
c. To avoid undue financial/business risk with the increase of debt.
d. The use of debt should be within the capacity of a firm. The firm
should be in a position to meet its obligation in paying the loan and
interest charges as and when due.
e. It should involve minimum possible risk of loss of control.
f. It must avoid undue restrictions in agreement of debt.
g. The capital structure should be conservative. It should be composed of
high grade securities and debt capacity of the company should never be
exceeded.
h. The capital structure should be simple in the sense that it can be easily
managed and also easily understood by the investors.
i. The debt should be used to the extent that it does not threaten the
solvency of the firm.

28.Briefly explain the meaning of optimal capital structure. Also explain why
it is important to select optimal capital structure.
Answer:
The theory of optimal capital structure deals with the issue of the right
mix of debt and equity in the long term capital structure of a firm.
This theory states that if a company takes on debt, the value of the firm
increases up to a point.
Beyond that point if debt continues to increase then the value of the
firm will start to decrease.
Also, if the company is unable to repay the debt within the specified
period then it will affect the goodwill of the company and may create
problems for collecting further debt.
Therefore, the company should select its appropriate capital structure
with due consideration to the other factors.

Page 18 of 55
CA Inter FM-ECO CA Mayank Kothari

29.Briefly why EBIT-EPS analysis is important while designing optimal

capital structure.
Answer:
EBIT-EPS analysis is a vital tool for designing the optimal capital
structure of a company.
The main objective of this analysis is to find the EBIT level that will
equate EPS regardless of the financing plan chosen.
The financial leverage affects the pattern of distribution of operating
profit among various types of investors and increases the variability of
the EPS of the firm.
Therefore, while searching for an appropriate capitals structure for a
firm, the financial manager must analyze the effects of various
alternative financial leverages on the EPS.
The effect of leverage on the EPS emerges because of the existence of
fixed financial charge (i.e., interest on debt and fixed dividend on
preference share capital).

30.Explain how the effect of fixed financial charge on the EPS depends upon
the relationship between the rate of return on assets and the rate of fixed
charge.
Answer:
The effect of fixed financial charge on the EPS extensively depends upon the
relationship between the rate of return on assets and the rate of fixed charge, which
has been explained in the following points:
If the rate of return on assets is higher than the cost of financing, then
the increasing use of fixed charge financing (i.e., debt and preference
share capital) will result in increase in the EPS.
This situation is also known as favorable financial leverage or
Trading on Equity.
On the other hand, if the rate of return on assets is less than the cost of
financing, then the effect may be negative and, therefore, the
increasing use of debt and preference share capital may reduce the EPS
of the firm.

Page 19 of 55
CA Inter FM-ECO CA Mayank Kothari

31.Briefly explain the reasons why the choice is jilted in favor of debt
financing, while choosing between debt financing and issue of preference
shares at the time of deciding fixed financial charge financing.
Answer:
The fixed financial charge financing may further be analyzed with
reference to the choice between the debt financing and the issue of
preference shares.
Theoretically, the choice is tilted in favor of debt financing for two
reasons:
i. The explicit cost of debt financing i.e., the rate of interest payable
on debt instruments or loans is generally lower than the rate of
fixed dividend payable on preference shares, and
ii. Interest on debt financing is tax-deductible and therefore the real
cost (after-tax) is lower than the cost of preference share capital.

32.Explain the concept of Financial Break-even and Indifference Analysis.

Answer:
A. Financial break-even:
Financial break-even point is the minimum level of EBIT needed
to satisfy all the fixed financial charges i.e. interest and preference
dividends.
It denotes the level of EBIT for which the company’s EPS equals
zero.
If the EBIT is less than the financial breakeven point, then the
EPS will be negative.
But if the expected level of EBIT is more than the breakeven
point, then more fixed costs financing instruments can be taken in
the capital structure, otherwise, equity would be preferred.
B. Indifference Analysis:
One method of considering the impact of various financing
alternatives on earnings per share is to prepare the EBIT chart or
the range of Earnings Chart.

Page 20 of 55
CA Inter FM-ECO CA Mayank Kothari

This chart shows the likely EPS at various probable EBIT levels.
The EPS may go down if another alternative of financing is
chosen even though the EBIT remains at the same level.
At a given EBIT, earnings per share under various alternatives of
financing may be plotted.
A straight line representing the EPS at various levels of EBIT
under the alternative may be drawn.
Wherever this line intersects, it is known as break-even point.
This is known as EPS equivalency point or indifference point
since this shows that, between the two given alternatives of
financing (i.e., regardless of leverage in the financial plans), EPS
would be the same at the given level of EBIT.

33.Write down the algebraic formula used to find out the equivalency or
indifference point.
Answer:
The equivalency or indifference point can also be calculated algebraically in
the following manner:
(EBIT − 11)(1 − T) (EBIT − 12)(1 − T)
! =
E1 E2
Where,
EBIT = Indifference Point
!E1 = Number of equity shares in Alternative 1
!E1 = Number of equity shares in Alternative 1
1! 1 = Interest charges in Alternative 1
1! 2 = Interest charges in Alternative 2

Page 21 of 55
CA Inter FM-ECO CA Mayank Kothari

Alternative 1 = All Equity Finance

Alternative 2 = Debt-equity Finance

34.What are the limitations of EBIT-EPS Analysis?

Answer:
If maximization of the EPS is the only criterion for selecting the
particular debt-equity mix, then that capital structure which is expected
to result in the highest EPS will always be selected by all the firms.
However, achieving the highest EPS need not be the only goal of the
firm.
The main shortcomings of the EBIT-EPS analysis may be noted as
follows:
i. The EPS criterion ignores the risk dimension:
➢ The EBIT-EPS analysis ignores as to what is the effect of
leverage on the overall risk of the firm.
➢ With every increase in financial leverage, the risk of the firm
and therefore that of investors also increases.
➢ The EBIT-EPS analysis fails to deal with the variability of
EPS and the risk return trade-off.
ii. EPS is more of a performance measure:
➢ The EPS, basically, depends upon the operating profit which,
in turn, depends upon the operating efficiency of the firm.
➢ It is a resultant figure and it is more a measure of
performance rather than a measure of decision making.

35.Explain how financial leverage can largely influence the value of the firm
through the cost of capital.
Answer:
The financial leverage has a magnifying effect on earnings per share,
such that for a given level of percentage increase in EBIT, there will be
more than proportionate change in the same direction in the earnings
per share.
The financing decision of the firm is one of the basic conditions
oriented to the achievement of maximization for the shareholders’
wealth.

Page 22 of 55
CA Inter FM-ECO CA Mayank Kothari

The capital structure should be selected in such a way that it not only
maximizes the value of the company and wealth of its owners, but also
minimizes the cost of capital.
As a result, the company is able to increase its economic rate of
investment and growth.
It is important to note that while financing mix cannot affect the total
earnings, it can affect the share of earnings belonging to the
shareholders.

36.Explain the concept of over-capitalization & under-capitalization.

Answer:
A. Over-capitalization:
It is a situation where a firm has more capital than it needs or in
other words assets are worth less than its issued share capital, and
earnings are insufficient to pay dividend and interest.
This situation mainly arises when the existing capital is not
effectively utilized on account of fall in earning capacity of the
company while company has raised funds more than its
requirements.
The chief sign of over-capitalization is the fall in payment of
dividend and interest leading to fall in value of the shares of the
company.
B. Under-Capitalization:
It is just reverse of over-capitalization.
It is a state, when its actual capitalization is lower than its proper
capitalization as warranted by its earning capacity.
This situation normally happens with companies which have
insufficient capital but large secret reserves in the form of
considerable appreciation in the values of the fixed assets not
brought into the books.

Page 23 of 55
CA Inter FM-ECO CA Mayank Kothari

37.Explain briefly the consequences of over-capitalization & under-

capitalization.
Answer:
A. Consequences of Over-Capitalization:
i. Considerable reduction in the rate of dividend and interest
payments.
ii. Reduction in the market price of shares.
iii. Resorting to “window dressing”.
iv. Some companies may opt for reorganization. However, sometimes
the matter gets worse and the company may go into liquidation.
B. Consequences of Under-Capitalization:
i. The dividend rate will be higher in comparison to similarly
situated companies.
ii. Market value of shares will be higher than value of shares of
other similar companies because their earning rate being
considerably more than the prevailing rate on such securities.
iii. Real value of shares will be higher than their book value.

38.Mention the causes of over-capitalization.

Answer:
Over-capitalization arises due to following reasons:
i. Raising more money through issue of shares or debentures than
company can employ profitably.
ii. Borrowing huge amount at higher rate than rate at which company can
earn.
iii. Excessive payment for the acquisition of fictitious assets such as
goodwill etc.
iv. Improper provision for depreciation, replacement of assets and
distribution of dividends at a higher rate.
v. Wrong estimation of earnings and capitalization.

39.What are the possible remedies in case over-capitalization & under-

capitalization occurs?
Answer:
A. Remedies in case over-capitalization:

Page 24 of 55
CA Inter FM-ECO CA Mayank Kothari

Following steps may be adopted to avoid the negative consequences of

over-capitalization:
i. Company should go for thorough reorganization.
ii. Buyback of shares.
iii. Reduction in claims of debenture-holders and creditors.
iv. Value of shares may also be reduced. This will result in sufficient
funds for the company to carry out replacement of assets.
B. Remedies in case under-capitalization:
Following steps may be adopted to avoid the negative consequences of
under capitalization:
i. The shares of the company should be split up. This will reduce
dividend per share, though EPS shall remain unchanged.
ii. Issue of Bonus Shares is the most appropriate measure as this will
reduce both dividend per share and the average rate of earning.
iii. By revising upward the par value of shares in exchange of the
existing shares held by them.

40.Mention the effects of under-capitalization.

Answer:
Under-capitalization has the following effects:
i. It encourages acute competition. High profitability encourages new
entrepreneurs to come into same type of business.
ii. High rate of dividend encourages the workers’ union to demand high
wages.
iii. Normally common people (consumers) start feeling that they are being
exploited.
iv. Management may resort to manipulation of share values.
v. Invite more government control and regulation on the company and
higher taxation also.

41.Explain over-capitalization vis-a-vis under-capitalization.

Answer:
Both over capitalisation and under capitalisation are not good.
However, over capitalisation is more dangerous to the company,
shareholders and the society than under capitalisation.

Page 25 of 55
CA Inter FM-ECO CA Mayank Kothari

The situation of under capitalisation can be handled more easily than

the situation of over-capitalisation.
Moreover, under capitalisation is not an economic problem but a
problem of adjusting capital structure.
Thus, under capitalisation should be considered less dangerous but
both situations are bad and every company should strive to have a
proper capitalisation.

Page 26 of 55
CA Inter FM-ECO CA Mayank Kothari

Practical Questions
1. Masco Limited wishes to raise additional finance of ₹10 lakhs for
meeting its investment plans. It has ₹2, 10,000 in the form of retained
earnings available for investment purposes. Further details are as
following:
You are required:

a) To determine the pattern for raising the additional finance.

Debt/equity mix 30%/70%

Cost of debt
Up to ₹1,80,000 10% (before tax)

Beyond ₹1,80,000 16% (before tax)

Earnings per share ₹4
Dividend pay out 50% of earnings
Expected growth rate in dividend 10%
Current market price per share ₹44
Tax Rate 50%

b) To determine the post-tax average cost of additional debt.

c) To determine the cost of retained earnings and cost of equity, and

d) Compute the overall weighted average after tax cost of additional finance.

Page 27 of 55
CA Inter FM-ECO CA Mayank Kothari

2. Best of Luck 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 Earnings 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%. (SM)

Page 28 of 55
CA Inter FM-ECO CA Mayank Kothari

3. Ganesha Limited is setting up a project with a capital outlay of

₹60,00,000. It has two alternatives in financing the project cost.

Alternative-I: 100% equity finance by issuing equity shares of ₹10

each

Alternative-II: Debt-equity ratio 2:1(equity shares will be of ₹10 each)

The rate of interest payable on the debts is 18% p.a. The corporate tax rate is
40%. Calculate the indifference point between the two alternative methods
of financing. (SM)

4. Ganapati 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.

Page 29 of 55
CA Inter FM-ECO CA Mayank Kothari

(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. (SM)

5. Shahji Steels Limited requires ₹25,00,000 for a new plant. This plant is
expected to yield Earnings before interest and taxes of ₹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 ₹2,50,000 or ₹10,00,000 or
₹15,00,000 and the balance, in each case, by issuing equity shares. The
company's share is currently selling at ₹150, but is expected to decline to
₹125 in case the funds are borrowed in excess of ₹10,00,000. The funds can
be borrowed at the rate of 10 percent upto ₹2,50,000, at 15 percent over
₹2,50,000 and upto ₹10,00,000 and at 20 percent over ₹10,00,000. The tax
rate applicable to the company is 50 percent. Which form of financing
should the company choose? (SM)

Page 30 of 55
CA Inter FM-ECO CA Mayank Kothari

6. Yoyo Limited presently has ₹36,00,000 in debt outstanding bearing an

interest rate of 10 per cent. It wishes to finance a ₹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 ₹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 ₹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? (SM)

7. Alpha Limited requires funds amounting to ₹80 lakh for its new
project. To raise the funds, the company has following two alternatives:

(i) to issue Equity Shares of ₹100 each (at par) amounting to ₹60 lakh and
borrow the balance amount at the interest of 12% p.a.; or

(ii) to issue Equity Shares of ₹100 each (at par) and 12% Debentures in
equal proportion. The Income-tax rate is 30%.

Find out the point of indifference between the available two modes of
financing and state which option will be beneficial in different situations.
(SM)

Page 31 of 55
CA Inter FM-ECO CA Mayank Kothari

8. 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 ₹3,60,000 and the overall
capitalisation 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.? (SM)

9. Rupa Ltd.’s EBIT is ₹5,00,000. The company has 10%, 20 lakh

debentures. The equity capitalization rate i.e. Ke is 16%.

You are required to calculate:

(i) Market value of equity and value of firm

(ii) Overall cost of capital.

(SM)

Page 32 of 55
CA Inter FM-ECO CA Mayank Kothari

10. Calculate the level of Earnings before interest and tax (EBIT) at which
the EPS indifference point between the following financing alternatives
will occur.

(i) Equity share capital of ₹6,00,000 and 12% debentures of ₹4,00,000.Or

(ii) Equity share capital of ₹4,00,000, 14% preference share capital of

₹2,00,000 and 12% debentures of ₹4,00,000.

Assume the corporate tax rate is 35% and par value of equity share is ₹10
in each case. (PM)

11. A new project is under consideration in Zip Ltd., which requires a capital
investment of ₹4.50 crores. Interest on term loan is 12% and Corporate
Tax rate is 50%. If the Debt Equity ratio insisted by the financing
agencies is 2: 1, calculate the point of indifference for the project.(PM)

12. RES Ltd. is an all equity financed company with a market value of
₹25,00,000 and cost of equity (Ke) 21%. The company wants to buyback
equity shares worth ₹5,00,000 by issuing and raising 15% perpetual
debt of the same amount. Rate of tax may be taken as 30%. After the
capital restructuring and applying MM Model (with taxes), you are
required to calculate:

(i) Market value of RES Ltd.

(ii) Cost of Equity (Ke)

(iii) Weighted average cost of capital (using market weights) and comment
on it.(PM)

Page 33 of 55
CA Inter FM-ECO CA Mayank Kothari

13. D Ltd. 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 0.862 0.743 0.641 0.552
(PM)
14. A Company earns a profit of ₹3,00,000 per annum after meeting its
Interest liability of ₹1,20,000 on 12% debentures. The Tax rate is 50%.
The number of Equity Shares of ₹10 each are 80,000 and the retained
Earnings amount to ₹12,00,000. The company proposes to take up an
expansion scheme for which a sum of ₹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) Advise the company as to which source of finance is preferable. (PM)

Page 34 of 55
CA Inter FM-ECO CA Mayank Kothari

15. 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 ₹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.(PM)
16. A Company needs ₹31,25,000 for the construction of a new plant. The
following three plans are feasible:

I. The Company may issue 3,12,500 equity shares at ₹10 per share.

II. The Company may issue 1,56,250 equity shares at ₹10 per share and
15,625 debentures of ₹100 denomination bearing a 8% rate of interest.

III. The Company may issue 1,56,250 equity shares at ₹10 per share and
15,625 cumulative preference shares at ₹100 per share bearing a 8%
rate of dividend.

(i) if the Company's Earnings before interest and taxes are ₹62,500,
₹1,25,000, ₹2,50,000, ₹3,75,000 and ₹6,25,000, what are the
Earnings per share under each of three financial plans ? Assume a
Corporate Income tax rate of 40%.

(ii) Which alternative would you recommend and why?

(iii) Determine the EBIT-EPS indifference points by formulae between

Financing Plan I and Plan II and Plan I and Plan III. (PM

Page 35 of 55
CA Inter FM-ECO CA Mayank Kothari

17. A firm has sales of ₹75,00,000 variable cost is 56% and fixed cost is
₹6,00,000. It has a debt of ₹45,00,000 at 9% and equity of ₹55,00,000.

(i) What is the firm’s ROI?

(ii) Does it have favourable financial leverage?

(iii) If the firm belongs to an industry whose capital turnover is 3, does it

have a high or low capital turnover?

(iv) What are the operating, financial and combined leverages of the firm?

(v) If the sales is increased by 10% by what percentage EBIT will

increase?

(vi) At what level of sales the EBT of the firm will be equal to zero?

(vii) If EBIT increases by 20%, by what percentage EBT will increase?

(PM, RTP, Nov 2017, Nov 2018)

18. X Ltd. is considering the following two alternative financing plans:

(₹)

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

The indifference point between the plans is ₹2,40,000. Corporate tax rate is
30%. Calculate the rate of dividend on preference shares.

(Nov-13, 5 Marks, PM)

Page 36 of 55
CA Inter FM-ECO CA Mayank Kothari

19. '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 ₹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.

(Nov-14, 5 Marks)

20. RST Ltd is expecting an EBIT of ₹4 lakhs for F.Y. 2015-16. Presently the
company is financed entirely by equity share capital of ₹20 lakhs with
equity capitalization rate of 16%. The company is contemplating to
redeem part of the capital by introducing debt financing. The company
has two options to raise debt to the extent of 30% or 50% of the total
fund.
It is expected that for debt financing upto 30%, the rate of interest will be
10% and equity capitalization rate will increase to 17%. If the company opts
for 50% debt, then the interest rate will be 12% and equity capitalization rate
will be 20%.

You are required to compute value of the company; its overall cost of capital
under different options and also state which is the best option.(Nov-15, 8
Marks)

Page 37 of 55
CA Inter FM-ECO CA Mayank Kothari

21. India Limited requires ₹50,00,000 for a new plant. This Plant is expected
to yield Earnings before interest and taxes of ₹10,00,000.
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 ₹5,00,000 or ₹20,00,000 or ₹30,00,000 and the
balance, in each case, by issuing equity shares. The company’s share is
currently selling at ₹150, but is expected to decline to ₹125 in case the funds
are borrowed in excess of ₹20,00,000. The funds can be borrowed at the rate
of 9 percent upto ₹5,00,000, at 14 percent over ₹5,00,000 and upto
₹20,00,000 and at 19 percent over ₹20,00,000. The tax rate applicable to the
company is 40 percent. Which form of financing should company choose?
Show EPS Amount upto two decimal points. (Nov-16, 8 Marks)
22. PNR Limited and PXR Limited are identical in every respect except
capital structure. PNR limited does not employ debts in its capital
structure whereas PXR Limited employs 12% Debentures amounting to
₹20,00,000. The following additional information are given to you:
(i) Income tax rate is 30%

(ii) EBIT is ₹5,00,000

(iii) The equity capitalization rate of PNR Limited is 20% and

(iv) All assumptions of Modigliani - Miller Approach are met.

Calculate:

(a) Value of both the companies,

(b) Weighted average cost of capital for both the companies. (May-17, 8
Marks)

Page 38 of 55
CA Inter FM-ECO CA Mayank Kothari

23. The X Ltd. is willing to raise funds for its new project which requires an
investment of ₹84 lakhs. The company has two options:

Option I : To issue Equity Shares (₹10 each) only

Option II : To avail term loan at an interest rate of 12%. But in this

case, as insisted by the financing agencies, the company will have to maintain
a debt equity proportion of 2:1.

The corporate tax rate is 30%.

Find out the point of indifference for the project.(Nov-17, 5 Marks)

24. The following current data are available concerning Theta Limited:
Share issued 10,000

Market price per share ₹20

Interest rate 12%
Tax Rate 46%
Expected EBIT ₹15,000

The company requires an additional ₹50,000 for the coming year.

You are required to determine:

(i) Which financing option (debt or equity issue) will give higher EPS for
the expected EBIT?

(ii) What is indifference level of EBIT for the two alternatives?

(iii) What is EPS for that EBIT?(RTP, Nov 2013)

Page 39 of 55
CA Inter FM-ECO CA Mayank Kothari

25. The following figures of Theta Limited are presented as under:

₹
Earnings before Interest and Tax 23,00,000
Less: Debenture Interest @ 8% 80,000
Long Term Loan Interest @ 11% 2,20,000 3,00,000
20,00,000
Less: Income Tax 10,00,000
Earnings after tax 10,00,000

No. of Equity Shares of ₹10 each 5,00,000

EPS ₹2

Market Price of Share ₹20

P/E Ratio 10

The company has undistributed reserves and surplus of ₹20 lakhs. It is in need
of ₹30 lakhs to pay off debentures and modernise its plants. It seeks your
advice on the following alternative modes of raising finance.

Alternative 1 - Raising entire amount as term loan from banks @ 12%.

Alternative 2 - Raising part of the funds by issue of 1,00,000 shares of ₹20

each and the rest by term loan at 12 percent.

The company expects to improve its rate of return by 2 percent as a result of

modernisation, but P/E ratio is likely to go down to 8 if the entire amount is
raised as term loan.

(i) Advise the company on the financial plan to be selected.

Page 40 of 55
CA Inter FM-ECO CA Mayank Kothari

(ii) If it is assumed that there will be no change in the P/E ratio if either of
the two alternatives is adopted, would your advice still hold good?

(RTP, May 2014)

26. 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. (RTP, May 2014)

Page 41 of 55
CA Inter FM-ECO CA Mayank Kothari

27. Theta Limited has a total capitalization of ₹10 Lakhs consisting entirely
of equity shares of ₹50 each. It wishes to raise another ₹5 lakhs for
expansion through one of its two possible financial plans.
(1) All equity shares of ₹50 each.

(2) All debentures carrying 9% interest.

The present level of EBIT is ₹1,40,000 and Income tax rate is 50%.

Calculate EBIT level at which Earnings per share would remain the same
irrespective of raising funds through equity shares or debentures.

(RTP, Nov 2014)

28. Akash Limited provides you the following information:

(₹)
Profit (EBIT) 2,80,000

Less: Interest on Debenture @ 10% 40,000

EBT 2,40,000

Less Income Tax @ 50% 1,20,000

1,20,000

No. of Equity Shares ( ₹10 each) 30,000

Earnings per share (EPS) 4

Price /EPS (PE) Ratio 10

Page 42 of 55
CA Inter FM-ECO CA Mayank Kothari

The company has reserves and surplus of ₹7,00,000 and required ₹4,00,000
further for modernisation. Return on Capital Employed (ROCE) is constant.
Debt (Debt/ Debt + Equity) Ratio higher than 40% will bring the P/E Ratio
down to 8 and increase the interest rate on additional debts to 12%. You are
required to ascertain the probable price of the share.

(i) If the additional capital are raised as debt; and

(ii) If the amount is raised by issuing equity shares at ruling market price.
(RTP, May 2016, Nov2017)

29. M/s. Sensation 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? (RTP, Nov 2016, Nov 2018)

Page 43 of 55
CA Inter FM-ECO CA Mayank Kothari

30. J Ltd. is an all equity financed company with a market value of

₹25,00,000 and cost of equity (Ke) 21%. The company wants to buyback
equity shares worth ₹5,00,000 by issuing and raising 15% perpetual debt
of the same amount. Rate of tax may be taken as 30%. After the capital
restructuring and applying MM Model (with taxes), you are required to
calculate:
(i) Market value of J Ltd.

(ii) Cost of Equity (Ke)

(iii) Weighted average cost of capital (using market weights) and comment
on it.

(RTP, Nov 2016, Nov 2018)

31. Company P and Q are identical in all respects including risk factors
except for debt/equity, company P having issued 10% debentures of ₹18
lakhs while company Q is unlevered. Both the companies earn 20%
before interest and taxes on their total assets of ₹30 lakhs.

Assuming a tax rate of 50% and capitalization rate of 15% from an all-equity
company. Compute the value of companies P and Q using (i) Net Income
Approach and (ii) Net Operating Income Approach.

(RTP, Nov 2015, May 2018)

Page 44 of 55
CA Inter FM-ECO CA Mayank Kothari

32. A Company needs ₹31,25,000 for the construction of a new plant. The
following three plans are feasible:
I. The Company may issue 3,12,500 equity shares at ₹10 per share.

II. The Company may issue 1,56,250 equity shares at ₹10 per share and
15,625 debentures of ₹100 denomination bearing an 8% rate of interest.

III. The Company may issue 1,56,250 equity shares at ₹10 per share and
15,625 preference shares at ₹100 per share bearing an 8% rate of
dividend.

(i) If the Company's Earnings before interest and taxes are ₹62,500,
₹1,25,000, ₹2,50,000, ₹3,75,000 and ₹6,25,000, what are the Earnings
per share under each of three financial plans? Assume a Corporate
Income tax rate of 40%.

(ii) Which alternative would you recommend and why?

(iii) Determine the EBIT-EPS indifference points by formulae between

Financing Plan I and Plan II and Plan I and Plan III.

(RTP, May 2017)

Page 45 of 55
CA Inter FM-ECO CA Mayank Kothari

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

production facilities and the following alternatives are available:

Alternative (₹in lakhs)

A B C
Share Capital 50 20 10
14% Debentures -- 20 15
18% Loan -- 10 25
Expected rate of return before tax is 25%. The rate of dividend of the
company is not less than 20%. The company at present has low debt.
Corporation tax rate is 50%. Which of the alternatives you would choose?

34. The following figures are made available to you:

₹
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

commencement of the year)
16,87,500
Less: Income Tax at 35% and dividend distribution tax 8,43,750
Profit after tax 8,43,750
Number of Equity shares (₹10 each) 1,00,000
Market quotation of equity share ₹109.70

The company has accumulated revenue reserves of ₹12 lakhs. The company is
examining a project calling for an investment obligation of ₹10 lakhs; this
investment is expected to earn the same rate of return as funds already

Page 46 of 55
CA Inter FM-ECO CA Mayank Kothari

employed. You are informed that a debt equity ratio higher than 45% will
cause the price Earnings ratio to come down by 25% and the interest rate on
additional borrowings on secured debentures. You are required to advise the
company on the probable price of the equity share, if

(a) the additional investment were to be raised by way of loans; or

(b) the additional investment were to be raised by way of equity.

35. MP Ltd. needs ₹20,00,000 for expansion. The expansion is expected to

yield an annual EBIT of 16%. In choosing a financial plan, MP Ltd. has a
objective of maximising Earnings per share.

It is considering the possibility of issuing equity shares and raising debt of

₹2,00,000 or ₹8,00,000 or ₹12,00,000. The current market price per share is
₹50 and is expected to drop to ₹40 if the funds are borrowed in excess of
₹10,00,000. Funds can be borrowed at the rates indicated below:

(a) Upto ₹2,00,000 at 8%.

(b) Over ₹2,00,000 and upto ₹10,00,000 at 12%.

(c) Over ₹10,00,000 at 18%. Assume tax rate of 40%.

Required: Determine the EPS for the three financing alternatives.

Page 47 of 55
CA Inter FM-ECO CA Mayank Kothari

36. A company's capital structure consists of the following:

Equity shares of ₹100 each ₹20,00,000

Retained Earnings ₹10,00,000
9% Preference Shares ₹12,00,000
7% Debentures ₹8,00,000
Total ₹50,00,000
The company earns 12% on its capital. The income-tax rate is 40%. The
company requires a sum of ₹25 lakh to finance its expansion program for
which following alternatives are available to it:

(i) Issue of 20,000 Equity Shares at a premium of ₹25 per share.

(ii) Issue of 10% Preference Shares.

(iii) Issue of 8% Debentures.

It is estimated that the P/E ratios in the cases of Equity, Preference and
Debenture financing would be 21.4,17 and 15.7 respectively.

Required: Which of the three financing alternatives would you recommend

and why?

37. The Evergrowing Company has to decide between debt fund and equity
for its expansion programme. Its current position is as follows:

Particulars ₹
5% Debt 40,000
Equity capital (₹10 per share) 1,00,000
Surplus 60,000
Total Capitalization 2,00,000
Sales 6,00,000
Less: Total Cost 5,38,000

Page 48 of 55
CA Inter FM-ECO CA Mayank Kothari

Income before interest and tax 62,000

Less: Interest 2,000
60,000
Income tax @ 40% 24,000
Income after tax 36,000
The expansion programme is estimated to cost 1,00,000. If this is financed
through debt, the rate of new debt will be 7% and the price Earnings ratio will
be 6 times. If the expansion programme is financed through equity shares, the
new shares can be sold net at 25 per share and the price to Earnings ratio will
be 7 times. The expansion will generate additional sales of 3,00,000, with a
return of 10% on sales before interest and taxes.

Required: If the company is to follow a policy of maximizing the market

value of its shares, which form of financing should it choose?

Page 49 of 55
CA Inter FM-ECO CA Mayank Kothari

38. The balance sheet of CANIH Ltd. as at March 31, current year is as
follows:

(Figures in lakhs of rupees)

Liabilities (₹) Assets (₹)

Share capital 200 Fixed asset 500

Reserves 140 Investments 300

Long-term loans 360 Receivables 240

Short-term loans 200 Cash and bank 60

Payables 120

Provisions 80
1,100 1,100
Sales for the current year were ₹600 lakhs. For the next year ending on March
31, they are expected to increase by 20 per cent. The net profit margin after
taxes and dividend payout are expected to be 4 and 50 per cent respectively.

Required:

(a) Quantify the amount of external funds required.

(b) Determine the mode of raising the funds given the following parameters.

(i) Current Ratio should be 1.33.

(ii) Ratio of fixed assets to long-term loans should be 1.5.

(iii) Long-term debt to equity ratio should not exceed 1.06.

(iv) The funds are to be raised in the order of (1) short-term bank
borrowings, (2) long-term to and (3) equities.

Page 50 of 55
CA Inter FM-ECO CA Mayank Kothari

39. The finance manager of KP Ltd has been trying to develop a financial
plan for the firm. He has, in coordination with other managers,
developed the following estimates (in lakh of rupees).

Particulars Year
1 2 3 4
Credit Sales Increase by
Increase by Increase by
20% Over
400 25% Over 40% Over
Previous
Previous Year Previous Year
Year
Fixed Assets
to Turnover 64% 56% 48% 40%
Ratio
In addition, for planning purposes, he has made the following estimates and
assumptions about other results.

Operating Ratio 60%

Cash Sales 20% of Total Sales
Return on sales (after taxes) 10%
Dividend Payout Ratio 68%
Turnovers (times) based on year-end values:
Debtors Velocity 3 Months
Stock Velocity 4 Months
Required Current Ratio 2:1
Required Debt Equity Ratio 1:2

At the beginning of year 1, the treasurer expects the firm to have capital
employed of ₹270 lakhs and Debt-Equity Ratio of 1 : 2.

Page 51 of 55
CA Inter FM-ECO CA Mayank Kothari

Required: Determine how much additional equity capital, if any, the firm will
have to issue each year, if the finance manager's estimates and assumptions
are correct.

40. A Ltd. has appointed you as its Finance Manager. The company wants to
implement a project for which ₹60 lakhs is required to be raised from the
market as a means of financing the project. The following financing plans
at options are at hand:

(Number in thousands)

Particulars 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% Nonconvertible Debentures 30 Nil 20
Assuming corporate tax to be 35 per cent and the face value of all the shares
and debentures to be ₹100 each, calculate the indifference points and Earnings
per share (EPS) for each of the financing plans. Which plan should be
accepted by the company?

41. The following data relate to two companies belonging to the same risk
class:

Particulars X Ltd. Y Ltd.

Expected Net Operating Income ₹50,000 ₹50,000
10% Debt ₹2,00,000 -
Equity Capitalization Rate 12.5% 10%
Required: (Use Net Income Approach)

Page 52 of 55
CA Inter FM-ECO CA Mayank Kothari

(a) Determine the Total Value and the Weighted Average Cost of Capital for
each of company assuming no taxed.

(b) State the effect on the Total Value and Weighted Average Cost of Capital
in part (a) if X Ltd. has decided to raise the debt by ₹1,00,000 and use
the proceeds to buyback equity shares.

(c) State the effect on the Total Value and Weighted Average Cost of Capital
in part (a) if the X Ltd. has decided to issue the equity shares by
₹1,00,000 and use the proceeds to redeem the debt.

42. X Ltd.'s expected annual net operating income (EBIT) is ₹50,000. The
Company has 10% Debt ₹2,00,000. The overall capitalization rate is
12.5%.

Required: (Use NOI Approach)

(a) Determine the Total market Value of the company and Equity
capitalization rate.

(b) Determine the Weighted Average Cost of Capital to verify the validity of
the NOI approach.

(c) State the effect on the Total Value of the company and Weighted Average
Cost of Capital in part (a) if X Ltd. has decided to raise the debt by
₹1,00,000 and use the proceeds to buyback equity shares.

(d) State the effect on the Total Value of the company and Weighted Average
Cost of Capital in part (a) if the X Ltd. has decided to issue the equity
shares by ₹1,00,000 and use the proceeds to redeem the debt.

Page 53 of 55
CA Inter FM-ECO CA Mayank Kothari

43. In considering the most desirable capital structure for a company, the
following estimates of the cost of debt and equity capital (after tax) have
been made at various levels of Debt-Equity mix:

Debt as % of Total Capital Cost of Equity

Cost of Debt (%)
Employed (%)
0 7.0 15.0
10 7.0 15.0
20 7.0 15.5
30 7.5 16.0
40 8.0 17.0
50 8.5 19.0
60 9.5 20.0
Required: Determine the optimal Debt-Equity mix for the company by
calculating composite cost of capital.

44. The following data relate to two companies belonging to the same risk
class:

Particulars X Ltd. Y Ltd.

Expected Net Operating Income ₹6,60,000 ₹6,60,000
10% Debt ₹30,00,000 -
Equity Capitalization Rate 20% 15%
Required:

(a) Determine the Total Value and the Weighted Average Cost of Capital for
each company assuming no taxes.

(b) Show the arbitrage process by which an investor who holds 10% equity
shares in X Ltd. will be benefited by investing in Y Ltd.

Page 54 of 55
CA Inter FM-ECO CA Mayank Kothari

(c) Will be gain by investing in the Undervalued Firm?

(d) Explain how he will be better off by investing the total funds available in
undervalued firm.

(e) When will this arbitrage process come to an end?

Page 55 of 55