- 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%
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- 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
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