IMPORTANT PROBLEMS

Capital structure theories are based on certain assumption to analysis in a single and
convenient manner:
• There are only two sources of funds used by a firm; debt and shares.
• The firm pays 100% of its earning as dividend.
• The total assets are given and do not change.
• The total finance remains constant.
• The operating profits (EBIT) are not expected to grow.
• The business risk remains constant.
• The firm has a perpetual life.
• The investors behave rationally.

Exercise 1
ABC Ltd., needs Rs. 30,00,000 for the installation of a new factory. The new factory expects
to yield annual earnings before interest and tax (EBIT) of Rs.5,00,000.
In choosing a financial plan, ABC Ltd., has an objective of maximizing earnings per share
(EPS).
The company proposes to issuing ordinary shares and raising debit of Rs. 3,00,000 and Rs.
10,00,000 of Rs. 15,00,000.
The current market price per share is Rs. 250 and is expected to drop to Rs. 200 if the
funds are borrowed in excess of Rs. 12,00,000. Funds can be raised at the following rates.
 –up to Rs. 3,00,000 at 8%
–over Rs. 3,00,000 to Rs. 15,000,00 at 10%
–over Rs. 15,00,000 at 15%
Assuming a tax rate of 50% advise the company.
Solution
Earnings Before Interest and Tax (BIT) less Interest Earnings Before Tax less: Tax@50%.

Alternatives
I II III
(Rs. 3,00,000 debt) Rs. 10,00,000 debt) (Rs. 15,00,000 debt)
5,00,000 5,00,000 5,00,000
24,000 1,00,000 2,25,000
4,76,000 4,00,000 2,75,000
2,38,000 2,00,000 1,37,500
2,38,000 2,00,000 1,37,500
27,00,000 20,00,000 15,00,000
250 250 200
10800 8,000 7,500
2,38,000 2,00,000 1,37,500
No. of shares 10,800 8,000 7,500
Earnings per share 22.03 25 18.33

The secure alternative which gives the highest earnings per share is the best. Therefore
the company is advised to revise Rs. 10,00,000 through debt amount Rs. 20,00,000 through
ordinary shares.

Exercise 2
Compute the market value of the firm, value of shares and the average cost of capital from
the following information.
Net operating income Rs. 1,00,000
Total investment Rs. 5,00,000
Equity capitalization Rate:
(a) If the firm uses no debt 10%
(b) If the firm uses Rs. 2,50,000 debentures 11%
(c) If the firm uses Rs. 4,00,000 debentures 13%
Assume that Rs.2,50,000 debentures can be raised at 6% rate of interest whereas
Rs. 4,00,000 debentures can be raised at 7% rate of interest.
Solution
Computation of market value of firm value of shares and the average cost of capital.
 Particulars (a) No Debt (b) Rs. 2,50,000 (c) Rs. 4,00,000
6% debentures 7% debentures
Net operating system 1,00,000 1,00,000 1,00,000
(–) Interest (i.e.)
Cost of debt _ 15,000 28,000
Earnings available to
Equity shareholders 1,00,000
85,000 72,000
Equity Capitalization Rate 10%
11% 13%
100
Market value of shares 1,00,000  100 100
10 85,000  72,000 
11 13
Rs. 10,00,000/-
Rs.772727/- Rs.553846/-
Market Value of firm 10,00,000 10,22,727 9,53,846

Average cost of capital

1,00,000 1,00,000 1,00,000
10,00,000 100 10,22,727 100 9,53,846 100
EBIT
Value of the firm

EBIT
=10%
V =9.78% =10.48%

Comments
From the above data, if debt of Rs. 2,50,000 is used, the value of the firm increases and the
overall cost of capital decreases. But, if more debt is used to finance in place of equity i.e.,
Rs. 4,00,000 debentures, the value of the firm decreases and the overall cost of capital
increases.

Exercise 3
Paramount Products Ltd. wants to raise Rs. 100 lakh for diversification project. Current
estimates of EBIT from the new project is Rs. 22 lakh p.a.
Cost of debt will be 15% for amounts up to and including Rs. 40 lakh, 16% for additional
amounts up to and including Rs. 50 lakh and 18% for additional amounts above Rs. 50 lakh.
The equity shares (face value of Rs. 10) of the company have a current market value of
Rs. 40. This is expected to fall to Rs. 32 if debts exceeding Rs. 50 lakh are raised. The
following options are under consideration of the company.

Option Debt Equity

I 50% 50%
II 40% 60%
III 60% 40%

Determine EPS for each option and state which option should the Company adopt.
Tax rate is 50%. (ICWA Inter Dec. 1997)
Solution
I II III
Equity 50,00,000 60,00,000 40,00,000
Debt 50,00,000 40,00,000 60,00,000
Amount to be raised 1,00,00,000 1,00,00,000 1,00,00,000
EBIT 22,00,000 22,00,000 22,00,000
Less: Interest of Debt 7,60,000 6,00,000 9,40,000
PBT 14,40,000 16,00,000 12,60,000
Less : Tax @ 50% 7,20,000 8,00,000 6,30,000
PAT 7,20,000 8,00,000 6,30,000
No. of equity shares 1,25,000 1,50,000 1,87,5,00
Rs. 5.76 Rs. 5.33 Rs. 11.73

Working Notes
Calculation of Interest on Debt

Total Debt I II III

Interest on: 50,00,000 40,00,000 60,00,000
Ist Rs. 40,00,000 @ 15% 6,00,000 6,00,000 6,00,000
Next Rs.10,00,000 @ 16% 1,60,000 – 1,60,000
Balance Rs. 10,00,000 @ 18% – – 1,80,000

7,60,000 6,00,000 9,40,000