Capital Structure, Cost of Capital and Value-Question Bank[1]

8/3/2019 Capital Structure, Cost of Capital and Value-Question Bank[1]

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Capital structure, cost of capital

and value

Question Bank

Prof. Prapti Paul


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1) XYZ ltd. has EBIT of Rs. 4,00,000. the firm currently has outstanding debts of

Rs.15,00,000 at an avg. cost of , kd of 10%. Its ke is estimated to be 16%.

I. Determine the current market value of the firm using traditional valuation approach

II. Determine the firms overall capitalization rate, ko.

III. The firm is considering to issue capital of Rs.5,00,000 in order to redeem Rs.5,00,000

debt. The cost of debt is expected to be unaffected. However the firms cost of equity

capital is to be reduced to 14% as a result of decrease in leverage. Would you

recommend the proposed action?

( answer: Total market value Rs. 30,62,500, ko=13.1% and proposal shd be accepted.)

2) NOI Ltd. belongs to a risk class of 10% and expects EBIT of Rs.4,00,000. it employs 8%

debt in the capital structure. Find out the value of the firm and the cost of equity

capital, ke, if it employs deb to the extent of 20%, 35% or 50% of the total financing

requirement of Rs.20,00,000.

(answer: value of firm at 20% debt= Rs.40,00,000; ke= 10.22%

value of firm at 35% debt = Rs. 40,00,000; ke= 10.42%

value of firm at 50% debt = Rs. 40,00,000; ke= 10.67%)


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3) A steel Ltd. has employed 15% debt of Rs.12,00,000 in its capital structure. The

NOI of the firm is Rs.5,00,000 and has a equity capitalization ratio of 16%.

Assuming that there is no tax, find out the value of the firm under NI

Approach. ( answer : value of the firm Rs.32,00,000).

4) The NOP of a firm is Rs.2,10,000 and the total market value of its 12% debt is

Rs.3,00,000. The equity capitalization rate of an unlevered firm of the same

risk class is 16%. Find out the value of the levered firm given that the tax rate is

30% for both the firms. ( answer: Rs.10,08,750).

5) S Ltd. and T ltd. are in the same risk class and are identical in all respects except

that the co. S uses debt while the co. T does not use debt. The levered firm has

Rs.9,00,000 debentures carrying 10% rate of interest. Both the firms earn 20%

operating profit on their total assets of Rs.15 lacs. The co. is in the tax bracket

of 35% and the capitalization rate of 15% on all equity shares. Compute the

value of S Ltd. and T Ltd. Using Net Income Approach. ( answer: Rs.18,10,000

and Rs.13,00,000 resp.)


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6) The foll is the data regarding 2 cos. X& Y belonging to the same risk class:

Co. X Co. Y

No. of eq. sh. 90,000 1,50,000

Market price per share (Rs.) 1.20 1.00

6% debentures (Rs.) 60,000 ---

Profit before interest (Rs.) 18,000 18,000

All profits after debenture interest are distributed as dividends. Explain how

under MM approach , an investor holding 10% of shares in Co. X will be better

off in switching his holding to Co. Y.

7) From the foll selected data, determine the value of the firms ,P &Q belonging

to the homogeneous risk class under: (a) NI Approach (b) NOI Approach.

Which of the firms has an optimal capital structure under each approach.

Firm P Firm Q

EBIT (Rs.) 2,25,000 2,25,000

Interest at 15% 75,000 -----

Ke 20% 20%

Tax rate 50% 50%


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8) Two cos., X and Y belong to the equivalent risk group. The 2 cos. are identical

in every respect except that the co. Y is levered while X is unlevered. The

outstanding amount of debt of the levered co. is Rs.6,00,000 in 10%

debenture. Other info is as foll:

X Y

Net operating income (EBIT) Rs. 1,50,000 1,50,000

- Interest ----- 60,000

Earnings to equity sh.hol 1,50,000 90,000

Ke .15 .20

Market value of equity 10,00,000 4,50,000

Market value of debt ------ 6,00,000

Total value of firm , V 10,00,000 10,50,000

Overall capitalization rate ko= EBIT/V 15% 14.3%

Debt equity ratio 0 1.33

An investor owns 5% equity shares of co. Y. Show the process and the

amount by which he could reduce his outlay through the use of arbitrage

process. Is there any limit to the process?


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9) K Ltd. has 10,00,000 equity shares of Rs. 10 each and 10% debentures of Rs.

14,00,000. the equity shares are traded at Rs.24 per share and the debentures

at par value. The return on equity shares is 20%. Find out the equity rate of

return applying the MM Model ( without taxes).

(answer ke= 16.31%)


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Capital structure: planning and designing1) Foll is the income statement of Aakash Ltd. :

Rs. In crores

Sales 500

COGS includes depreciation 250

Selling & admin expenses 50

EBIT 200

Taxes @35% 70Net income 130

The co.s cost of capital is 11% and its net assets are worth Rs.800 crores.

i) What is the conventional return on investment?

ii) What is the net addition to the wealth of sh.hol in the current year in

terms of economic value added?

( answer: ROI= 16.25% and EVA= Rs.42 crores).


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2) Alpha co. is contemplating conversion of 500, 14% convertible bonds of

Rs.1,000 each. Market price of the bond is Rs.1,080. bond indenture provides

that 1 bond will be exchanged for 10 shares. P/E ratio before redemption is

20:1 and anticipated P/E ratio after redemption is 25:1. No. of shares

outstanding prior to redemption are 10,000 shares. EBIT amounts to

Rs.2,00,000. The co. is in the 35% tax bracket. Should the co. convert bonds

into shares? Give reasons.

3) G Motors Ltd., a producer of turbine generators, is in this situation : EBIT =

Rs.40 lakhs; tax rate=T=35%; debt outstanding =D=Rs.20 lakhs; rate of

interest= 10%; ke= 15%; shares of stock outstanding =No.=6,00,000; book

value per share= Rs. 10. since Gs product market is stable and the co. expectsno growth, all earnings are paid out of dividends. The debt consists of

perpetual bonds. What is the Gs EPS and price per share Po?

G can increase its debt by Rs.80 lakhs, to a total of Rs.1 crore, using the

new debt to buy back and retire some of its shares at the current price. Its

interest rate on debt will be 12% ( it will have to call and refund the old debt),

and its cost of equity will rise from 15% to 17%. EBIT will remain constant.Should G change its capital structure?

Capital Structure, Cost of Capital and Value-Question Bank[1]

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