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solution_capital structure

The document presents a financial analysis comparing levered and unlevered firms, detailing their EBIT, interest, equity capitalization rates, and values of equity and debt. It also discusses the arbitrage process for an investor holding stakes in both firm types, calculating returns and the impact of capital structure on firm valuation. Additionally, it examines the weighted average cost of capital (WACC) for varying equity and debt levels across firms.

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3 views

solution_capital structure

The document presents a financial analysis comparing levered and unlevered firms, detailing their EBIT, interest, equity capitalization rates, and values of equity and debt. It also discusses the arbitrage process for an investor holding stakes in both firm types, calculating returns and the impact of capital structure on firm valuation. Additionally, it examines the weighted average cost of capital (WACC) for varying equity and debt levels across firms.

Uploaded by

f20221840
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as XLSX, PDF, TXT or read online on Scribd
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Particulars/Firm U L

EBIT 100000 100000


Interest 50000 0
Earnings available to SHs 50000 100000 Assume no taxes
Equity capitalisation rate 0.16 0.125
Value of Equity 312500 800000
Value of Debt 500000 0
Value of the Firm 812500 800000

Artibrage Process
(i) IF X holds 10% of Levered firm
X's Position in Levered Firm
10% of equity 31250
10% Debt 50000
10% of investment in X 81250
Returns to Mr. X 5000

(ii) X position with 10% investm,ent in unlevered firm

10% Equity 80000


X's Own funds 31250
Borrowed funds 50000
10% investment 80000
Returns available in U for 10000
Interest on borrowed funds 5000

(iii) Returns due to Arbitrage

Investment in U 81250
Return in U 10156.25
interest 5000
Returns for Mr. X in U 5156.25
Returns for Mr. X in L 5000
Returns due to arbitrage 156.25
Source:6th Edition: FINANCIAL
MANAGEMENT
TEXT, PROBLEMS AND CASES, M Y Khan & P K Jain
Unlevered Levered Firm
EBIT 150 150
Cost of Capital (WA 0.2 0.2
Cost of Debt 0.1
Interest 0 20
tax 0.35 0.35
EAT 97.5 97.5
Value of firm 487.5 557.5

Determining the cost of equity

Value of debt 200


Value of Equity( Value of the f 357.5
Cost of Equity 0.2 0.236364
1. Companies U and L are identical in every respect except that the former does not use d
its capital structure while the latter employs Rs. 6,00,000 of 15 percent debt. Assumin
(a) all the M.M. assumptions are met (b) the corporate tax rate is 50 percent (c) the EBIT
2,00,000 and (d) the equity capitalization of the unlevered company is 20 percent. What
the value of the firms. U and L? Also, determine the weighted average cost of capital fo
the firms.

Firm U Firm L
EBIT 200000 200000
Interest 0 90000
E BT 200000 110000 Cost of deb 0.15
Tax 100000 55000 Tax rate 0.5
EAT 100000 55000
Cost of Equity 0.20 0.275
Value of Equity 500000 200000
Value of Debt 0 600000
Value of the Firm 500000 800000
WACC 0.20 0.125
the former does not use debt in
15 percent debt. Assuming that,
is 50 percent (c) the EBIT is Rs.
pany is 20 percent. What will be
average cost of capital for both
100% equit70% Equity50% Equity
EBIT 150000 150000 150000
Interest 0 30000 60000
EBT 150000 120000 90000
Cost of equity 0.16 0.188235 0.205714
Value of Equity 937500 637500 437500
Cost of Debt 0 0.1 0.12
Value of Debt 0 300000 500000
Value of the firm 937500 937500 937500
WACC 0.16 0.16 0.16

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