- What is Capital Structure?
- What do you understand by Capital Structure?
- Basic patterns of Capital Structure- Explain it
- Define Capital Structure. List out the Determinants of Capital Structure.
- List out the characteristics of balanced capital structure
- Explain the theories of Capital Structure in brief.
- What do you know about MM Approach and Traditional Approach? List out the solutions of problems related to Capital Structure.

**Check out these examples to understand the Capital Structure Approaches:**

**Problem No. 1:**

Following data has been estimated for the equity capital investment (after tax) and cost of debt at various intervals of debt-equity mix.

**Debt (%) of total capital Cost of Debt (%) Cost of Equity (%)**

0 5.0 12.0

10 5.0 12.0

20 5.0 12.5

30 5.5 13.0

40 6.0 14.0

50 6.5 14.6

60 7.0 20.0

Consider the organization has desired capital structure. Calculate composite cost of capital by determining optimal debt-equity mix.

**Solution:**

**Organization’s Composite Cost of Capital (after tax)**

**Debt (%) Cost of Debt (%) Cost of Equity (%) Composite **

**of total capital Cost of Capital**

** **

0 5.0 12.0 5 x 0 + 12 x 1 = 12.00

10 5.0 12.0 5 x .10 + 12 x .90 = 11.30

20 5.0 12.5 5 x .20 + 12.5 x .80 = 11.00

30 5.5 13.0 5.5 x .30 + 13 x .70 = 10.75

40 6.0 14.0 6 x .40 + 14 x .60 = 10.80

50 6.5 14.6 6.5 x .50 + 16 x .50 = 11.25

60 7.0 20.0 7.0 x .60 + 20 x .40 = 12.20

**Problem No. 2:**

- Murugappa & Co has the equity capitalization rate of their organization at 10 %. The net income of 8% debentures for $2,00,000 is $80,000. Determine as per NI Approach:
- Market value of the firm
- Overall cost of capital

- Suppose its debentures value is increased to reach $3,00,000, then Calculate:
- Overall cost of capital
- Market value of the firm

Neglect income tax statistics.

**Solution:**

**Market value of the firm:**

V = S + B

Where,

V = Value of firm

S = Value of equity

B = Value of debt = NI/ Ke

**Calculating the value of debt, B:**

B = 64,000/ 10/ 100

= 64,000 x 100/ 10

= $6,40,000

**Now,**

**Computation of Net Income (NI):**

NI = 80,000

Less : Amount available for equity share holders

after the Interest on 8% debentures of $2,00,000 = 16,000

Ke : Equity Capitalization Rate of 10% = 64,000

Hence, value of the firm will become $8,40,000

**Overall cost of capital:**

K = EBIT/ V x 100

Where,

EBIT = Earnings before the Interest and Tax

Therefore,

K= 80,000/ 8,40,000 x 100

= 9.52%

**When the debenture debt is raised to $3,00,000**

NI (Net Income) = 80,000

Less : Amount available for equity share holders

after the Interest on 8% debentures of $3,00,000 = 24,000

Ke : Equity Capitalization Rate of 10% = 56,000

Value of Debentures will be-

56,000 x 10/ 100

= $5,60,000

Hence, value of the firm will become 8,60,000

**Overall cost of capital:**

K = EBIT/ V x 100

= 80,000/ 8,60,000 x 100

= 9.3%

**Note:**

After calculating the overall cost of capital and value of firm in both cases, it is observed that:

- With an increase in debt financing, the value of the firm also increased
- And the overall cost of capital gets decreased

**Problem No. 3:**

M/sNagu Ltd., has programmed a major expansion that requires another investment where its share capital is $1,00,000 is $50,000. The share capital has been divided into 10,000 equity-shares of $10 each. The management has taken steps to raise the funds through:

- Issue of 5,000 for 12% preferences shares of $10 each
- Issue of 5,000 for equity shares of $10 each
- Issue of 50,000 for 10% debentures

Its present EBIT is $40,000 per annum. Calculate the effect on the organizationdue to the implementation of the above methods on the financing of earnings per share.

Assume:

- EBIT will remain the same even after its implementation
- EBIT is raised to $10,000 where tax rate at 50%

**Solution:**

**EBIT will remain the same even after its implementation**

** **

**Particulars Present Capital Structure Proposed Capital Structure**

**All Equity ($) (i) All Equity ($) (ii) Equity (iii) Equity**

**+ Pre ($) + Debt ($)**

EBIT 40,000 40,000 40,000 40,000

Less : Interest – – – 5,000

PBT 40,000 40,000 40,000 35,000

Less : Tax 20,000 20,000 20,000 17,500

PAT 20,000 20,000 20,000 17,500

Less : Pre. Dividend – – 6,000 –

**Profit availability for equity **

Shareholders 20,000 20,000 14,000 17,500

Available amount

for shareholders 20,000 20,000 14,000 22,500

Number of

Equity shares 10,000 15,000 10,000 10,000

EPS 2 1.33 1.40 1.75

Dilution against

Initial EPS of $2 – .67 .60 .25

**Note: **From the above table, it has been observed that when funds are raised by issue of debentures, the dilution of earnings per share is least.

**EBIT is raised to $10,000 where tax rate at 50%**

** **

**Particulars Present Capital Structure Proposed Capital Structure**

**All Equity ($) (i) All Equity ($) (ii) Equity (iii) Equity**

** + Pre ($) + Debt ($)**

EBIT 40,000 50,000 50,000 50,000

Less : Interest – – – 5,000

PBT 40,000 40,000 40,000 45,000

Less : Tax 20,000 25,000 25,000 22,500

PAT 20,000 25,000 25,000 22,500

Less : Pre. Dividend – – 6,000 –

**Profit availability for equity **

Shareholders 20,000 25,000 19,000 22,500

Available amount

for shareholders 10,000 15,000 10,000 10,000

Number of

Equity shares 10,000 15,000 10,000 10,000

EPS 2 1.67 1.90 2.25

Changes in the EPS

against initial of $2 – 2 – .33 – .10 +.25

**Note: **From the above table, it has been observed that present funds have been raised by $0.25 per share when funds rise by issue of debentures. Hence, it has been proved that issue of debentures is essential to increase capital funding of earnings per share.

**Problem No. 4:**

Two firms B and S have 6% of debt of $3.00 Lakhs and zero debt respectively. Both the firms are identical in all other aspects and earn an EBT of $1,20,000 each. Calculate the market value of both these firms considering corporate tax of 60% and equity capitalization rate of 10%.

**Solution:**

**Value of unlevered firm can be calculated as,**

Vu = Profits available for equity shareholders/ Equity Capitalization Rate

= (I – t) EBT/ Ke

Where,

Earnings Before Tax (EBT) = 1,20,000

Less : Tax Rate (1,20,000 x 0.6) = 72,000

Profit available for equity shareholders = 48,000

Hence,

Vu = (1,20,000 – 72,000)/ 10/ 100

= 48,000 x 10

= $4,80,000

**Value of levered firm can be calculated as,**

Vi = Vu + Bt

Where,

Vi = Value of levered firm

Vu = Value of unlevered firm = 4,80,000

B = Amount of debt = 3,00,000

t = Tax Rate = 0.6

Hence,

Vi = 4,80,000 + 3,00,000 x 0.6

= $5,60,000

**Problem No. 5:**

Ram Ltd. has a new project that requires an investment of $150 Lakhs. Its tax rate is at 50% while the interest rate on loan is 12%. Considering the debt-equity ratio of financing agencies as 2 : 1. Now calculate the point of indifferencein terms of project completion.

**Solution:**

As the financing agencies have put debt-equity ratio of 2 : 1, some possible alternatives should be checked:

- With the issue of shares, increase the total capital investment of the company
- To maintain the debt-equity ratio of 2 : 1, raise $50 Lakhs by issue of shares and $100 Lakhs by debt

With the above possibilities structured above, the first case will have zero interest and second case will be of $12 Lakhs.

**Computation of Point of Indifference:**

It can be calculated by:

(X – I1) (1 – T) – PD / S1 = (X – I2) (1 – T) – PD / S1

Where,

X = Break Even EBIT level or Point of Indifference

T = Tax Rate

PD = Preference Dividend

I1 = Interest Under Plan 1

I2 =Interest Under Plan 2

S1 = Number of Equity Shares of Plan 1

S2 = Number of Equity Shares of Plan 2

Now,

(X – 0) (1 – 0.5) – 0 / 15 = (X -12) (1 – 0.5) – 0 / 5

(X x 0.5) / 15 = (X – 12) 0.5 / 5

2.5 X = 7.5 X – 90

5 X = 90

Hence, X = $18 Lakhs

**Note:**

Here, the EBIT at the point of indifference has been observed as $18 Lakhs. This means earnings on equity (after tax) will be 6% per annum. It will not depend on whether the financing capital is the debt-equity mix or fully equity. The rate of interest on debt will be 12%.

**Problem No. 6:**

- SLM Ltd. has 6% debenturedebt for $10,00,000 of its net operating income $2,00,000. Its overall capitalization rate is 10%. Determine the market value of firm and calculate the equity capitalization rate as per NOI Approach
- Calculate the equity capitalization rate and value of firm if debenture is decreased to $7,50,000.

**Solution:**

**NOI Approach:**

To calculate value of the firm,

S = V – B

Where,

S = Value of equity

V = Value of firm

B = Value of debt = $10,00,000

S = 20,00,000 – 10,00,000

= $10,00,000

Now,

V = EBIT/ Ke

EBIT = Earnings Before Interest and Tax = 2,00,000

Ke = Equity Capitalization Rate = 10%

Hence,

Value of firm, V = 2,00,000/ 10/ 100

= 20,00,000

**Equity Capitalization Rate,**

Ke = EBIT – I/ (V – B) x 100

Now,

S = V – B

= 20,00,000 – 10,00,000

= $10,00,000

Hence,

Ke = 2,00,000 – 60,000/ (10,00,000) x 100

= 14%

**Debenture is decreased to $7,50,000**

To calculate value of the firm,

S = V – B

Where,

V = $20,00,000

B = $7,50,000

S = 20,00,000 – 7,50,000

= $12,50,000

**Equity Capitalization Rate,**

Ke = EBIT – I/ (V – B) x 100

Now,

S = $12,50,000

Hence,

Ke = 2,00,000 – 45,000/ (12,50,000) x 100

= 12.4%

**Links of Previous Main Topic:-**

- Budget and budgetary control
- Limitations of historical accounting
- Introduction to responsibility accounting
- Introduction to financial management
- Introduction and types of dividend
- Concept of cost of capital
- Capitalization meaning

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