Management)

(Financial
House
Publishing
SBPD

48 Summer Co.
Amar Co
Solution
Particulars

80,000 80,000
Tax 10,000
Interest and
Profit before 70,000
Interest on
Debentures
80,000
Less
40,000 35,000
Profit before ta::
(50% assumed) 40,000 35,000
Less Income tax 16,000
Profit after tax
Dividend on
Preference
Shares
40,000 19,000
Less
Profit for Equity
Shareholders
5,00,000 2,00,000
Equity Share Capital 40,000x100 19,000x 100
5,00,000 2,00,000
8% = 9.5%

Dividend on Equity Share Capital

llustration 2 Both are engaged in the

Ltd. and Ankit Ltd.
There are two companies namely Ankur
invested 75,000 each. Anku
business and both have capital
same line of manufacturing
from Equity Shares of T 10 each
and T 25,000 from 10-
Ltd. has raised its capital { 50,000
debentures of 100 each. Ankit ltd. has raised its whole
capital from equity shares ofF 1
each.
Comment on the policy of Trading on Equity followed by Ankur Ltd. of the pre-tar
profit before debenture interest is 10,000 each in both the companies.
Solution Trading on Equity
Particulars Ankur Lid. Ankit Ltd.
Profit before Interest and tax 10,000 10,000
Less: Interest onDebentures 2,500
Profit before tax
Less Income tax
7,500 10.000
(50% assumed 3,750 5,000
Profit for Equity Shareholders
Equity Share Capital
3,750 5,000
50,000
- 75,000
3750 x 100
5,000 x 100
50.000 75,000
Dividend on
Equity Share Capital. = 7.5%
6-67%
Illustrution 3.
****

***

Rathi Lid. has a

Capital Structure exelusively of
5,00,000.
extensiou
The company desires
to raise additional ordinary shares amounting
programme. funds of T 5,00,000 for financing
G)It can raise the The company has four alternatives: 1
entire amount in
ii) It
can raise 50% as equity the form of equity capital.
(1) It can raise capital and 50% as E%
(v It
the entire
amount as 6%% debentures.
can raise 50%o as
equity debentures.
EBIT is 7 60,000.capital and 50% as 6%
The
existing
number 5,000 and the The tax rate is preference
capitál.
market 50%.
Which financing price
plan should theper share is 100 under all Outstanding ordinary
shares
firm select ? the four alterhatives.
 Capital Structure-Concept and Theories 49
Solution:
The
The existing capital employed and EBIT are 5,00,000 and T 60,000 respectively.
additional funds will increase the amount of capital employed to the tune of 7 1,00,000.

This Will also increase EBIT as under:

000
5,00,000 10.00,000 =71,20,000
Note: It is assumed that EBTI Will increase at the sáme rate.
Financial Plans
Proposal Proposal Proposal Proposal
IInd Illrd IVth
Ist
Earnings before Interest and Tax 1.20,000 1,20,000 1,20,000 1,20,000
Less Interest on Debentures 12,500 30,000
1,07,500 90,000 1,20.000
Earnigs before Tax 1,20,000
Income Tax @ 50% 60,000 53,750 45,000 60,000
Less
60,000 53,750 45,000 60,000
Profit after Tax
Less : Dividend on Preference Shares 15,000

Profit for Equity Share holders 60,000 53,750 45,000 45,000

7,50,000 5,00,000 7,50,000
Equity Share capital 10,00,000
60,000x100 53,750 x100 45,000x100 ,000x 100
7,50,000 5,00.000 7.50,000
10.00,000
9% = 6
Dividend on. Equity Share Capital = 6% 7.17%
Comments : It is clear from the above illustration that the firm should select plan
III. because rate of earning (Dividend on equity share capital) is maximum (9%) in the plan.
llustration 4
in 5,000 equity shares of T 100
Chanakya Ltd. capitalised with { 5,00,000, dividend finance
is
a major programme
each. The management wishes to raise another 5,00,000 to
The management may finance
of expansion through one possible financing plans.
of four
all the equity shares, (2) 2,50,000 in
the company with the following methods-(1) By All debt @ 6% interest, or
equity shares and 7 2,50,000 in debt at 5% interest, (3)
(4) F 2,50,000 in equity shares and 2,50,000, 5% preference shares.
interest and taxes amounted to 7 60,000. In
company's existing earnigs before
The ? Comment
Which proposal should be accepted by company
come-tax is assumed to be 50%.
also.
Solution IV
Particulars Proposal I |Proposal II | Proposal 111 ; Proposal
1.20.000 1,20,000 1,20,000 1,20,000
Profit betfore Interest and Tax 30,000
12,500
Less Interest
1,20,000 1,07,500 90,000 1,20,000
Profit before Taxes8 45,000 60,000
60,000 53,750
Less Income tax (50%)
60,000 53,750 45,000 60,000
Profit after Tax 12,500
Less Dividend on Preference Shares 47,500
60,000 53,750 45,000
Shareholders
Profit for Equity 7,50,000
10,00,000 7,50,000 5,00,000
Equity Share Capital
6% 7.17% 3% 6.33%
Dividend on Equity Share Capital
 Managemenl)
( F i n a n c i a l
iinvests it

Th
c o m p a n y

House
the income.
when
Publishing or
that r e t u r n

of 9o
SBPD
arnalysis
above maximum
the
50 clear
from
shareholders
get a
It is
:t h e n has been
C o m m e n t

equity III. 1 0 , 0 0 , 0 0 0

debts,
for
proposal
this
I n coming
fiva
capital
in should opt o u t of
4,00,000
20,00,000 debentures.
F
of T 5%
c o m p a n y

the 2,40,000,
llustration 6 invested
capital through
80,000,
< Comment on
total 7 10,00,000
tax F is
50%.
has remaining and i n c o m e - t a x

interest
company and
A through equity before corporate
raised
expects
too earn
The r a t e of
company respectively.
20.000
years
50.000
and s h a r e h o l d e r s .

to equity Years
the earnings
4 5
3
Solution
Particulars
2 20.000
50,000
4,00,000
2.40,000
1,80,000
Profit before tax 50,000
50,000 50,000
and interest

50,000 30,000
Less Interest on 50,000 3,50,000
NIL
debentures 5% 1,90,000
1,30,000 NIL NIL
Profit before tax 1,75,000
95,000
Less Income taX 65,000
NIL-30,000
@50% 1,75,000
for Equity 65,000
95,000
Profit available
Shareholders
95,000x 100
1,75,000.x 100|
Share
65,000x 100 10,00,000
10,00,000
Earnings o n Equity 10,00,000 17.5%
Capital (%) 6.5%
9.5%
income of equity
three year_ in first
above facts that in the fourth year
C o m m e n t s : It is
clear form tne company's income but
in debenture
s h á r e h o l d e r s have increased
due to increase pay i n t e r e s t to the
was used to the profit droped
down to F 50,000.which In the fifth year
the firms profit dropped shareholders did not get
anything. holders.
holders and the equity the interest to the debenture
not enough to pay off s h a r e h o l d e r s would
down to 7 20,000 which was This year the equity
incurred a loss ofT 30,000.
Thus the firm actually
not get anything.
Illustration 6
31st December, 2007
Following is the capital
structure of X Ltd. on

10% Bank Loans 3,00,000

9% Debentures 11,00,000
11% Preferenee Shares (of 100 each) 12,00,000
20,00,000
Equity Shares (of T 100 each)
14,00,000
Reserve Funds
60,00,000
F 9,60,000. The
At present, the earnings of the company before interest and tax
are
existing rate of return is expected to be maintained in füture also. The
company require
6,00,000 for expansion programme. Following options are available to manage the funds
(i) Issue of equity shares at a premium ofT 20 each. (ii) Issue of 11% preference shares
at par. (ii) Issue of 2,500 equity shares at a premium of T 20 each and 11% preference
shares at par for the remaining amount. (iv) Issue of 10% debentures at par
Assuming tax rate as 40%o, which option is the best for the company ?
 Capital Structure-Concept and Theories 51
Solution: Statement showing Earning per Share
Present I IV
Particulars Position

Earning before 9,60,000 10,56,000 10,56,000 10,56,000 10,56.000

Interest and Tax
Less: Interest ona (-) (-
Borrowed Capital 99,000 (-) 99,000
9% Debentures 99,000 30,000 99,000 30.000 99,000
10% Bank Loan 30,000 30,000 30,000
10% Debentures (New) 60,000
Earnings before tax 8,31,000 9,27,000 9,27,000 9,27,000 8,67,000
Less Tax @ 40% 3,32,400 3,70,800. 3,70,800 3,70,800D 3,46,800
Earnings after tax 4,98,600 5,56,200 5,56,200 5,56,200 5,20.200
Less Preference
Dividendd 1,32,000 1,32,000 1,98,000 1,65,000 1,32.000
Earnings for Equity
3,58,200 3,91,200 3,88,200
Shares 3,66,600 4,24,200
No. of Equity Shares 20,000 25,000 20,000 22,500 20,000

Earning per Equity

Share 18.33 16.97 17.91 T17.39 19.41
% Change in E.P.S. -2.29 5.13
(-)7.42 (+)5.89
should be selected by the
Comments : Its clear from the above analysis that plan IV
company because EPS
is maximum (19.41) in this plan.
Ilustration.7
under
The Capital Structure of two companies Sourav and Gourav are as
Sourav Ltd. Gourav Ltd.

2,00,000 40,000
Paid up Equity Capital 1,20,000 40,000
Reserves 40,000 40,000
10% Pref, Share Capital
40,000 280,000
5% Debentures
Total 4,00,000 4,00,000
structure of both compaies.
Comment upon the capital
Solution:
Equity Capital +Reserves and Surplus
Finance
Capital Gearing Ratio
=
Preference Capital + Interest Bearing
2,00,000+
1,20,000
Ltd.=
Sourav 40,000+40,000
3,20,0004:1
80,000
40,000+40,000
G o u r a v Ltd. = 40.000 +2,80,000

80,000 1:4
3,20,000 is low while Gourav limited's
limited 's capital gearing ratio of income more
Comments: Sourav bear the fluctuations
is high. Sourav limited can interest and fixed dividend is less.
Capital gearing ratio because the burden
of fixed
Gourav Limited
easily than
 (Financial Management)
House
SBPD Publishing
52 limiteu face
an em
greater risk than equity
shareholders of
Gourav
the equity the same reason.
Not only this Sourav limited because of
shareholders of
Illustration 8 Tata Ltd. and Bata Ltd. Th.
gearing of the two companies
Comment on the Capital
are:
conmpanies
capital of both Tata Ltd.

5,00,000
Shares of 1,000 each
500, 8% Pref. 1,00,000
each
100 Equity Shares ofR 1,000 50,000
Reserves 50.000
500; 10% Debentures of i 100 each 7,00,000

Bata Ltd.

5,00,000
500, 8% Pref. Shares of T 1,000 each 1,50,000
150 Equity Shares of 1,000 each 10,000
Reserves 40,000
400, 10% Debentures of 100 each 7,00,000
The proit before tax and interest of each company is as follows. Tax rate is'50% :

2006 2,00,000
2007 1,80,000
Solution: Trading on Equity
Tata Ltd. Bata Ltd.
2006 2007 2006 2007

Profits
Less: Interest on Debentures @ 10% 2,00,000 1,80,000 2,00,000 1,89,000
5,000 5,000 4,000 4,000
Profit before tax 1,95,000
Less: Income tax @50%
1,75.000 1,96,000D 1.76,000
97,500 87,500 98,000 88,000
Profit after tax
97,500 87,500 98,000 88,000
Less: Pref. Share IDividend 40,000 40,000- . -
40,000 40,000
Profit available for Equity Shareholodeis
Equity Share Capital 57,500 47,500 58,000 48,000
1,00,000 1,00,000 1,50,000 1,50,000
Rate of Dividend on Equity Shares
57-5% 475% 38-6} 32%

Capital Gearing Ratio = Equity Share Capital + Reserve and Surplus

Pref, Share Capital+ Interest
Tata Ltd, = 00,000 +50,000 bearing inance
5,00,000+50,000
1,50,000
5,50,000 273
Bata Ltd=460,000
6,40,000 296
the
Comments: It is clear that there
amour are lat of diffa
 Capital Structure-Concept and Theories 53

gearing ratio is more than Tata Ltd. has a dividend rate of 38.6% in 2006 and 32% in 2007.
The market price of equity shares of Tata Ltd. will be more than Bata Ltd.
llustration 9
There are three following alternatives for a company having a total capital of
10,00.000
Alternatives

Equity Shares 9,50,000

3,50.000 7,00,000
Reserves 50,000 50,000
7% Preference Shares 2,00,000 3,00,000
8% Debentures 4,00,000
10,00,000 10,00,000D 10,00,000
Assuming the profit before tax and interest on debentures is 1.50,000 and tax rate
is 50% comment on. trading on equity and capital gearing ratio.
Solution Trading on Equity

Profit before tax and interest 1,50,000 1,50,000 1.50.000

Less: Debentures Interest @ 8% 32,000

Profit before tax 1,18,000 1,50,000 1,50,000

Less Income tax (assumed 50%) 59,000 75,000 75,000

59,000 75,000 75,000

Profit after tax
Less : Pref. Share Dividend @ 7% 14,000 21,000

Profit available for equity shareholders 45,000 54,000 75,000

3,50,000 7,00,000 9,50,000
Equity Share Capital
45
oE X 100
350
54
xx
700
100 75 100
x950 100
Rate of Dividend
12-86%b = 7.71% 7-89%
Equity Share Capital + Reserves
Ratio
Capital Gearing Pref. Share Capital + Interest bearing Finance
=-

I 3,50,000+50,000
2,00,000 +4,00,000
4,00,000=0.67: 11
6,00,000

II 7,00,000-2.33:1
3,00,000
III =,50,000
+50,000
Nil
the above result that the option having
lower capital
Comment: It is clear from equity shares. Option Ihas the lowest capital
ratio has a greater rate of dividend on i.e, 12.86%, Thus
gearing dividerd rate on equity shares is
maximum
gearing ratio 0.67 1 and its
option I is the best.
 Management
(Financial
Publishing
House
SBPD
D E B T C A P A C I T Y

of princina
54 every
year
and repayment

whether a
firm
interest fact
of regular of the compulso
danger of
irrespective
payment met w i t h the
have to be
involves
Use debt
of firm is
f a c e d
the size of
existino
which the
obligations
r e l a t i o n to
maturity. These failing in
on
or going
in loss; determined
be
earning profit
must
limits of
debt
Hence,
liquidation.
EBIT of the firm. DEBT-EQUITY RAT1O
hand and 'equity'
probable the o n e
'debt' o n
between creditors and shareholder
establishes
relationship
the relative
claims of of computin
This ratio evaluates the m e t h o d
on the other. It a r e two
views regarding
be taken into accoun
'owned-capital' There debt should
the income and
assets of the firm. view only long-term total debt. The
contention
on to one e x c l u d e d from
ratio. According liabilities should be should be excludei
debt-equity t h e r e f o r e it
debt o r
current and
and short-term variations s h o r t - t e r m debt
also repr
from frequent
debt suffers view argues
that
therefore it should
is that short-term ratio. The
other
of risk, and
while computing
debt-equity the degree
exercises a n impact
on
debt-equity ratig
liability and debt-equity ratio. Below
sents a firm's while computing
be included in
long-term debt method.
according to both the
has been computed shareholders equity
and overall
(a) On the basis of long-term debt
Long-term Borrowed Capital
+ + Reserves Preference Capital
Debt-equity tadlo Eauity Share Capital
(b) On the basis oftotal debt and
overall shareholders equity
_Long-termDebt +Current
Liabilities
Debt-equity Ratio = Shareholders Equity
In the
debt in only 50% of shareholders overall equity1
In the first case long-term to shareholders
+ current borrowings) is equal
second case tota! debt (long-term borrowings indicative of the
debt-equity ratio is rather low which may be
equity. In both the cases, is not much and the creditors funds are safe. It may also indicate
fact that the degree of risk least in normal income years) is withn
that the debt servicing burden on the company (at
not be in the interest of
reasonable limits. Nevertheless, such a low debt-equity ratio may
financial leverage specially
equity shareholders because it deprives them of the benefit of
in good profit years. Why should not a company with high profit earing capacity employ
return on owners funds ? It is to be noted that debt
more debt so as to maximise rate of
related tax-saving operating and financia
is a cheaper source of capital as it involves
leverages. (Chapter No. 8 of this book):i)a o : ,
Illustration 10
Calculatethe Debt-Equity Ratio from the following Balance Sheet
Balance Sheet

Share Capital 1,60,000 Fixed Assets 2.40,000

Reserves 1,60,000 Current Assets 1,60,000
Long-term Liabilities 60,000
Current Liabilities 20,000
4,00,000 4,00,000
Solution:
Debt-Equity Ratio Share Borrowed
= Capital
1in other words it can
Capital +
be said the Reserves and Surpiusdebt.
owners equity is twice the value
of longterm
 Capital Structure-Concept and Theories

60,000+20,000
1,60,000+1,60,000
80,000
320,000
= 0.25 1
Comments: It is clear from the above ratio that 7 1 is available with the organisation
for every T 0.25 of outside liability. Hence the money of creditors is safe.
Illustration 11
The Balance Sheet of Samurai Ltd. is as
follows:
Equity Share Capital 1,00,000Goodwill
60,000
Capital Reserve 20,000ixedAssets 1,40,000
Mortgage Loan 80,000 Stock 30,000
Creditors 40,000ebtors 30,000
Bank Overdraft 10,000 nvestments 10,000
Taxation Cash in hand 30,000
Current 10,000
Future 10,000 20,000
Profit and Loss appropriaion
30,000

3.00.000 3.00.000

Calculate Debt-Equity Ratio and comment.

Solution:
Debt-Equity Ratio =Borrowed
Proprietor'sCapital
Fund

1,50,000
1,50,000
= 1:1
Borrowed Capital =
80,000+ 40,000 + 10,000 +20,000 ={ 1,50,000
1,00,000 +20,000+30,000 = 1,50,000
Proprietor's Fund
that in the total capital of the company
Comment: It is clear from the above analysis indicator of a
This is an
creditors (lenders) is equal.
the share of proprietors and outside
good state of long term solvency.
2.Solvency Ratio
is calculated
firm. It by dividing the total
shows the degree of solvency of
a
This ratio
will be computed as follows
assets by total debt. This ratio
Total Assets 100
Solvency Ratio =Total Debt
Or
Total Assets-Fictitious Assets
Solvency Ratio Total Outside Liabilities
=-

for debt or borrowed funds as provided

by the book
cover then
It shows the extent of safety be more than 100 per
cent. In case it is 100%
should always the business
value of assets. The ratio (or owned funds) and
the has no equity capital situation not usually
t would m e a n that on the basis of borrowed funds (a very r a r e
company

entirely
18 carried on

found in acutal practice.)

 Management)
House (Financial
SBPD Publishing
60 as to which
alternative of debt-equity
e s t i m a t e s suggest
the above cost the company.
On the basis of capital
s t r u c t u r e to

a n optimum
mix will provide

Solution Debt) (Kex Ratio of Equity)

Ko= (Ki x Ratio of +

of Capital
Where, Ko Composite Cost
=

Ki Cost of Debt
Ke = Cost of Equityy
Capital
Composit Cost of Composite Cost of
Cost of Debt Cost of Equity
Debt as Percantage
Capital Percentage
Percentage (Koi
Aiternatwe Percentage of (Ki) e
Tbtal Capital 13.50
+ ( 7 5 x 0.16) =
25 (25 x 0.06) 12.50
(50 x 0.18)
=
+
50 (50 x 0.07) 11.00
(75 x 0.08) + (25 x 0.20)=
75
the company an
C (Debt-Equity Mix of 75 : 25) will give
It is clear that alterr.ative Cost of Capital) will be minimum
because the Ko (Composite
optimun capital-structure
under this alternative.
EBIT/EPs RELATIONSHIP
for designing an appropriate
EBIT/EPS Analysis provide a very useful measure on EPS
can
of the firm at various
reveals the impact
structure for the firm. This analysis level of EBITT
capital alternative financial plans. Given a particular
levels of EBIT under various (or a debt-equity
will try his best to design a capital structure
every financial manager limits for the
EPS (of course within the debt capacity
mix) which can provide the highest and a major
to m e a s u r e the firm's performance
firm). This is because EPS is a yardstick value of
factor in determining the value of the firm. As maximisation of the
contributory becomes imperative for
the firm is one of the basic objectives of financial management, it
which c a n succeed in minimising the
a financial manager to design a capital structure
time maximise the market value of
overall cost of capital of the firm and can at the same
the shares of the firm.
At a higher level of EBIT a financial manager can induct more debt-capital in the
capital structure, which will certainly give added benefit to equity-holders by way of higher
EPS; ultimately resulting in incerasing the value of the firm. This creates the necessity of
be
computing EPS at various levels of EBIT, under alternative financial plans. Can there
anEBIT at which EPS would be the same irrespeetive of any debt-equity mix ? Certainly
such an EBIT level can be computed which can provide equal EPS under any debt-equity
mix. This level of EBIT will be indicative of indifference point or break-even level of EBIT
INDIFFERENT POINT
It indicates a point or level of EBIT at which EPS is the same irrespective of debt-equity
financial plan adopted. This point or level of EBIT is also called the break-even point. How
to determine this indifference point or level of EBIT ? The following example ilustrates
the method of doing so.
llustration 17.
A firm is planning to invest 20,00,000 in a new project. Two alternative financial
plans are under consideration: Plan A is 100% equity plan to finance the project by selling
2,00,000 equity shares of 10 each. Plan B is 50% equity and 50% debt plan; that is to
financethe project by selling 1,00,000 equity shares of 10 each and 10,000 (15%) debentures
of 100 each.
The conpany expects to eern 25% return on total long-term capital before interest
and taxes (EBIT Level). Tax rate for the
company is 50%.
 61
Capital Structure-Concept and Theories
of the above data, compute indifference point or level of EBIT which will
On the basis
break-even EPS.
Solution
The formula for computing EPS under 100% equity plan in as follows

EPS =
(EBIT -i)(1-t)
Ni
The formula for conmputing EPS under 50-50 debt-equity plan is also the same as given
below
EPS=EBIT-) (1 -t)
N2
Computing the Indifference Point
As EPS is equal at the break-even or indifference level of EBIT; the following equation
when solved will give the value of indifference level of EBIT
(-i)(1-) -i) (1-
Ni N
where
=
Earnings before interest and taxes (EBIT)
Interest on debt
Marginal Rate of Tax
N1 =
Number of equity shares under Plan 'A' (100% equity plan)
N2 Number of equity shares under Plan B (50 : 50 debt-equity plan)
Solving the above equation by substituting the relevant data as given in the example
we get
Plan 'A' Plan B
(100% Equity) (50 50 Debt-equity)
a-i)(1) i ) 1-t)
Ni N2
x-0) (1-0.5) (x1,50,000) (1 - 0-5)
2,00,000 1,00,000
a (0-5) x (05)-75,000
2,00,000 1,00,000
By multiplying the above equation by 1,00,000, we get,
0-5 x 0-5 x-75,000
2 1

0.5x = 2 (0.5x -

75,000)
0.5 x = x -

1,50,000
0.5 x = 1,50,000

1,50,000 x2 7 3,00,000
Therefore, Indifference or Break-even Level of EBIT = T3,00,000.
It means that given the above variables EPS will be the same under the two financial
plans at EBTlevel of 3,00.000; which is the indifforence point at which EPS breaks even.
This can be verified as follows