# Test Questions of Capital Structure

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1. What is Capital Structure?
2. What do you understand by Capital Structure?
3. Basic patterns of Capital Structure- Explain it
4. Define Capital Structure. List out the Determinants of Capital Structure.
5. List out the characteristics of balanced capital structure
6. Explain the theories of Capital Structure in brief.
7. 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:

1. 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:
1. Market value of the firm
2. Overall cost of capital
2. Suppose its debentures value is increased to reach \$3,00,000, then Calculate:
1. Overall cost of capital
2. Market value of the firm

Neglect income tax statistics.

Solution:

1. 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%

1. 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:

1. With an increase in debt financing, the value of the firm also increased
2. 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:

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

Solution:

1. 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.

1. 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:

1. 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

1. 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:

1. With the issue of shares, increase the total capital investment of the company
2. 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:

1. 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
2. Calculate the equity capitalization rate and value of firm if debenture is decreased to \$7,50,000.

Solution:

1. 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%

1. 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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