CAPITAL STRUCTURE THEORIES

1. A firm is expected to generate net operating earnings of Rs.20,00,000 which market capitalizes at that rate ke, at 20%. Assume that it has Rs. 25,00,000 in debt at 16% interest, given this information, calculate value of firm using NI approach.

2. Assuming no taxes and given the earning before interest and taxes(EBIT), Interest (I), at 10% and equity capitalization rate (K), below, calculate the total market value of each firm using NI approach:

Firms EBIT I KX 2,00,000 20,000 12%Y 3,00,000 60,000 16%Z 5,00,000 2,00,000 15%W 6,00,000 2,40,000 18%

Also determine the weighted average cost of capital for each firm.

3. (a) A company expects a net income of Rs.80,000. It has Rs. 2,00,000 , 8% Debentures. The equity capitalization rate of the company is 10%. Calculate the value of the firm and overall capitalization rate according to Net Income Approach (ignoring tax).

(b) If the debenture debt is increases to Rs. 3,00,000, what shall be the value of firm.

4. The operating income of a firm is Rs. 50,000. The cost of debt is 10%. Outstanding debt is Rs. 2,00,000. If the overall cost of capital is 12.5%, what would be the total value of the firm and the equity capitalization rate?

5. (a) A company expects a net operating income of Rs. 1,00,000. It has Rs. 5,00,000 6% debentures. The overall capitalization rate is 10%. Calculate the value of the firm and the equity capitalization rate according to Net Operating Income Approach.

(b) If the debenture debt is increased to Rs. 7,50,000. What will be the effect on the value of the firm and equity capitalization rate?

6. Summer Ltd. And Winter Ltd. are identical in all respects including risk factor except for Debt/ Equity Mix. Summer Ltd. having issued 12% debentures of Rs. 30 lakhs, while winter Ltd. issued only equity capital. Both the companies earn 24% before interest and taxes on their total assets of Rs. 50 lakhs. Assuming the corporate effective tax rate of 40% and capitalization rate of 18% for an all equity company.Compute the value of summer Ltd. and Winter Ltd. using (i) Net Income Approach and (ii) Net operating income approach.

7. (a) A firm has EBIT of Rs. 40,000. The firm has 10% debentures of Rs. 1,00,000 and its current equity capitalization rate is 16%. Calculate current value of firm and overall cost of capital using traditional approach.(b) If firm is considering to increase its leverage issuing additional Rs. 50,000 debenture and using the proceeds to retire that amount of equity. However if firm increases proportion of debt Ki would rise to 11% and Ke to 17%. What will be the effect on the value of the firm and overall capitalization rate?© ) If firm is considering to increase its leverage issuing additional Rs. 1,00,000 debenture and using the proceeds to retire that amount of equity. Due to increased financial risk , Ki would rise to 12.5% and Ke to 20%. What will be the effect on the value of the firm and overall capitalization rate?

8. Companies U and L are identical in every aspect, except that the former does not use debt in its capital structure, while the later employs Rs. 6,00,000 of 15% debt. Assuming that:

a. All the MM assumptions are metb. Corporate tax rate is 50%c. The EBIT is Rs. 2,00,000d. The equity capitalization of the unlevered company is 20%,

What will be the value of firms U & L? Also determine the weighted average cost of capital for both the firms.

9. The following is the data regarding two companies ‘X’ and ‘Y’ belonging to the same equivalent risk class:

Company X Company YNumber of ordinary Shares 90,000 1,50,000Market Price per share Rs. 1.2 Rs. 16% Debentures 60,000 ------Profit before interest Rs. 18000 Rs. 18000

All profit after debentures interest are distributed as dividends.

Explain how under Modigilani & Miller approach, an investor holding 10% of shares in Company ‘X’ will be better off in switching his holding to Company ‘Y’.

(MU MMS 2010)

10. The two companies, Q & R, belong to an equivalent risk class. These two firms are identical in every respect except that Q company is unlevered while Company R has 10% debentures of Rs. 30 lakh. The other relevant information regarding their valuation and capitalization rates are as follows:

Particulars Firm P Firm QEBIT 7,50,000 7,50,000Less: Interest   3,00,000EATESH 7,50,000 4,50,000Ke 0.15 0.2Market Value of Equity (S) 50,00,000 22,50,000Market Value of Debt (B)   30,00,000Total Value of Firm (V=S+B) 50,00,000 52,50,000Implied overall cost of capital(Ko) 0.15 0.143Debt Equity Ratio (B/S) 0 1.33

(a) An investor owns 10% equity share of company Q. Show the arbitrage process and the amount by which he could reduce his outlay through the use of leverage.

(b) According to Modigilani & Miller, when will this arbitrage process come to an end?

11. The companies ACC Cements and Dalmia Cements belong to same risk class and are identical in every fashion except ACC Cements uses debt while Dalmia Cement does not. The leveraged company has Rs.9,00,000 debenture carrying 10% rate of interest. Both firms earn 20% before interest and taxes on their total assets of Rs. 30 lakhs. Assume perfect capital market, rational investors and so on; Both companies pay tax at 40% and capitalization rate for an all equity company is 15%.You are required to:

a. Compute the value of the two firms using the Net Income and Modigilani-Miller Approach.

b. Using the M.M. approach, Compute the overall capitalization rate for both the companies.

(MU MMS 2011)

12. Following information is available from the books of XYZ Ltd:

Rs. in LakhsSales 500Cost of Raw Materials 200Labour cost of manufacturing 100Interest on Borrowings 60

The capitalization rate for debt is 10% and the capitalization rate for the entire firm is 12.5%. Assuming that the firm does not retain any earnings and there is no tax, As per NOI approach:

a) What is the total market value of firm?

b) What is the market value of debt of the firm?

c) What is the market value of the equity of the firm?

d) What is the equity capitalization rate?

(MU MMS 2009)