FINANCIAL MANAGEMENT CA - INTERMEDIATE QUESTIONNAIRE BOOK CA. Prashant Sarda B. Com., F.C.A.© Exclusive publication, distribution and promotion rights reserved with the Publisher. Price: € 250 Every affrt has bean made fo avoid errars or omission in this publication, ln spite ofthis, erors may creep in. Any mistake, error or dscrepaney noted may be brought fo our notice which shall be taken care of Inthe ‘ext ation. Ils nolified that ner tha Author nor the Sella wl be responsible for any damage or loss of ‘action to any one, of any kind, in any manner, Uirotm, Its Suggested thal lo avols any doubt the ceader Should eross-check all the fects, law and contents of the publeation with the lnstiute’s publication or rotieatione No part ofthis book shall be reproduced or copied in any form or by any moans (graphic, electronic or ‘mechanical, including photocopying, recording, taping, or information rerieval ster, or fepcaduced on ary isk, tape, periorated media or other infomation storage device, otc. without the writen permission of the ‘author. Breach ofthis conaiton i lable for legal acon.PREFACE To all readers, I am proud to present this book along with Team Expert. I have spent time writing this with a student perspective in mind. Each chapter has broken down core concepts and expanded on them with diagrams and tables, as and when possible. It is my goal to help each and every holder of this book to be able to fight against the odds and win. Victory presents itself with the backing of Rnowledge, practice and expertise. ‘This book provides a valuable window on the subject and covers the necessary components chapter by chapter. The challenges in this subject are both difficult and interesting. People are working on them with enthusiasm, tenacity, and dedication to develop new methods of analysis and provide new solutions to keep up with the ever-changing threats. In this new age of global interconnectivity and interdependence, it is necessary to stay relevant, for both professionals and students. This book is a good step in that direction and would not have been possible without my team, my colleagues, my students and everyone that has supported me in my journey as aA professional. For any feedback or questions based on the material covered within the book, please feel free to contact me via email. Regards, CA Prashant Sarda caprashantsarda@ gmail.com 8007766008CA INTERMEDIATE FINANCIAL MANAGEMENT QUESTIONNAIRE INDEX Cae NAME OF THE TOPIC ana 7 SCOPE & OBJECTIVES OF FINANCIAL MANAGEMENT 1 to 3 2 ‘| LEVERAGES 4 to 16 3 | CAPITAL STRUCTURE 17 to 33 4 | COST OF CAPITAL 34 to 48. 5 | FINANCIAL ANALYSIS & PLANNING - RATIO ANALYSIS | 49 to 6& 6 | TYPES OF FINANACING (NO PRACTICAL QUESTION) 7 | INVESTMENT DECISION - CAPITAL BUDGETING 69 to 90 & | DIVIDEND DECISIONS 97 to 99 9 | MANAGEMENT OF WORKING CAPITAL 700 to 118 MCQ INDEX Coane Waa aaa an 1 SCOPE & OBJECTIVES OF FINANCIAL MANAGEMENT 119 to 121 2 | LEVERAGES 122 to 128 3 | CAPITAL STRUCTURE 729 to 133 4 | COST OF CAPITAL 731 to 143 5 | FINANCIAL ANALYSIS & PLANNING - RATIO ANALYSIS | 144 to 157 6 | TYPES OF FINANACING (NO PRACTICAL QUESTION) 752 to 158 7 | INVESTMENT DECISION - CAPITAL BUDGETING 159 to 165 & | DIVIDEND DECISIONS 766 to 169 9 | MANAGEMENT OF WORKING CAPITAL 170 to 175www.myeduneeds.com CHAPTER 1 SCOPE & OBJECTIVES OF FINANCIAL MANAGEMENT PROBLEM 1 ‘You want to endow a prize that would pay & 100,000 per annum, You want to make a one — time payment because you are not sure where you would be during subsequent years. If the time value is 10%, how much will you have to invest today? Solution: PV of infinite annuity = A/r Where A =% 100,000, r= 10% PV = 100,000/10% = & 10,00,000 /- Thus, you need to invest € 10,00,000 today. PROBLEM 2 Find out the present value of a 4 year annuity of € 20,000 discounted at 10 percent. Solution: PV of finite annuity = Ax PVAF (rn) Where A =% 20,000 r= 10% & n=4 years PV = 20,000 x 3.1699 =8 63,398 /= ‘Thus, the PV is & 63,398 /- PROBLEM 3 What is the present value of an income stream which provides € 1,000 at the end of year one, & 2,500 at the end of year two and & 5,000 during each of the year 3 through 10, if the discount rate is 12 percent. Solution: Statement showing computation of Present Value Year Particulars CF DF @ 12% DCF 1 Cash in flow 7000 0.8929 893 2 Cash in flow’ 2500 0.7972 1993 3-10 Cash in flow 5000 3.9602, 19,801 22,687 PROBLEM 4 ‘What is the present value of an income stream which provides € 2,000 a year for the first five yea 3,000 a year forever thereafter, if the discount rate is 10 percent? Solution: For 2,000 p.a. for the first 5 years PV of finite annuity = Ax PVAF (rn) Where A =% 2,000 r= 10% & n= 5 yearswww.myeduneeds.com pv = 2,000 x 3.7908 = & 7,582 /- For € 3,000 p.a. forever after the first 5 years PV of infinite annuity at the end of S" year = A/r Where A =%3,000 r= 10% PV at the end of S* year = 3,000/10% = 30,000 /- pv = FV x PVF (rn) pv = 30,000 x 0.6209 =& 18,628 /- Total PV = 7,582 + 18,628 =€ 26,210 PROBLEM 5 ‘A finance company makes an offer to deposit a sum of € 1,100 and then receive a retum of € 80 pa perpetually. Should this offer be accepted if the rate of interest is 8% Will the decision change if the rate of interest is 5%? Solution: Part A: When discount rate is 8% PV of infinite annuity = Alt Where A = 801=8% Pv = 80 / 8% =F 1,000 Thus, PV of future annuity is € 1,000 /- whereas we need to invest 1,100 /- therefore the offer should be rejected Part B: When discount rate is 8% PY of infinite annuity = A/r Where A =%801=5% Pv = 80 / 5% =F 1,600 - Thus, PV of future annuity is & 1,600 /- whereas we need to invest & 1,100 /- therefore the offer should be rejected PROBLEM 6 Assume that a deposit is to be made at year zero into an account that will eam 8% compounded annually. It is desired to withdraw % 5,000 three years from now and & 7,000 six years from now. What is the size of the ‘year zero deposit that will produce these future payments, Solution: Statement showing computation of Present Value Year Particulars CF DF @ 12% DCF 3 Cash in flow 5000 0.7938 3,969 6 Cash in flow 7000 0.6302 44h 8,380 Thus, we need to invest € 8,380 /- today to withdraw & 5,000 after 3 years & & 7,000 after 6 years.www.myeduneeds.com PROBLEM7 Assume that a 20,00,000 plant expansion is to be financed as follows: The firm makes a 15% own payment and borrows the remainder at 9% interest rate. The loan is to be repaid in 8 equal annual installments beginning 4 years from now. What is the size of the required annual loan payments. Solution: Today’s borrowing amount: 20,00,000 -15% | =% 17,00,000 /- PV of finite annuity = Ax PVAF (n,n) Where PV =%17,00,000 r= 9% & n=4 11 years (8 installments) 17,00,000 = Ax 4.2739 =F 3,97,763 /- Thus, the annual loan installment is € 3,97,763 /- PROBLEM 8 Raj has invested & 1,00,000 in computer system and wishes to give on lease. Life of the computer system is 5 yeas without any scrap value, What should be the annual lease rent, if lessor’s opportunity rate of interest is 20% p.a, Solution: PV of finite annuity = Ax PVAF (rn) ‘Where PV =%1,00,000 r= 20% & n=5 years 1,00,000 = Ax 2.9906 =% 33,438 /- Thus, the annual lease rental is € 33,438 PROBLEM 9 ‘You need & 10,000 for buying textbooks next year. You can earn 7% on your money. How much do you need to invest today? Solution: PV =FVx PVF (rn) V = 10,000 x 0.9346 =F 9,346 /- Thus, you need to invest & 9,346 /- today to buy text books after I year.www.myeduneeds.com CHAPTER 2 LEVERAGES PROBLEM 1 A Company produces and sells 10,000 shirts. The selling price per shirt is € 500. Variable cost is shirt & fixed operating cost is € 25,00,000. 200 per a) CALCULATE operating leverage. b) If-sales are up by 10%, the COMPUTE the impact on EBIT? Solution: a) Statement of Profitability z Sales Revenue (10,000 x 500) 50,00,000 Less: Variable Cost (10,000 x 200) 20,00,000 Contribution 30,00,000 Less: Fixed Cost 25,00,000 5,00,000 Operating L Contribution _ 30 lakhs )perating Leverage -—T STakhe = 6 times % Change in EBIT b) Operating Leverage (OL) = 5G srgein Sales 6 x /'5,00,000 ~5,00,000/50,00,000 X — -=%3,00,000 + AEBIT = 3,00,000 / 5,00,000 = 60% PROBLEM 2 CALCULATE the operating leverage for each of the four firms A, B, C and D from the following price and cost dati A® B®) D® | Sale price per unit 20 32 50 70 | Variable cost per unit 6 16 20 50 Fixed operating cost 60,000| 40,000 1,00,000 | Nil | What calculations can you draw with respect to levels of fixed cost and the degree of operating leverage result? Explain, Assume number of units sold is 5,000.www.myeduneeds.com Solution: Firms x B c D Sales (units) 5,000 5,000 5,000 5,000 Sales revenue (Units x price) @) 1,00,000} —1,60,000| 2,590,000, 3,50,000 Less: Variable Cost (30,000)| (80,000) | (1,00,000) | (2,50,000) (Units x variable cost per unit) @) 70,000 80,000] 1,590,000, 1,00,000 Less: Fixed operating costs @) (60,000)| (40,000) | (1,00,000) Nil [eBIr 10,000 40,000 50,000 | __1,00,000 - Sales (8 Costs (vO) DoL ‘current EBIT 2,00,000~ 30,000 DoL(A) = eT 2,60,000 - 80,000 DOL(B) = SSeS 2 +) = 250,000 ~ 1,00,000 _ DOLIC) 50,000 DoLp) = 280g0= 280000 _ | 14,00;000 The operating leverage exists only when there are fixed costs. In the case of firm D, there is no magnified effect on the EBIT due to change in sales. A 20 per cent increase in sales has resulted in a 20 per cent increase in EBIT. In the case of other firms, operating leverage exists. It is maximum in firm A, followed by firm C and minimum in firm B. The interception of DOL of 7 is that 1 per cent change in sales results in 7 per cent change in EBIT level in the direction of the change of sales level of firm A. PROBLEM 3 A firm's details are as under: Sales (@ 100 per unit) % 24,00,000 Variable Cost 50% Fixed Cost = 10,00,000 Ithas borrowed F 10,00,000 @ 10% p.a. and its equity share capital is € 10,00, 000 ® 100 each). Consider tax @ 50%, CALCULAT! a) Operating Leverage b) Financial Leverage ©) Combined Leverage 4) Return on Investment ©) If the sales increases by & 6,00,000; what will the new EBIT?www.myeduneeds.com Solution: z Sales 24,00,000 Less: Variable cost 12,00,000 Contribution 12,00,000 Less: Fixed cost 10,00,000 EBIT 2,00,000 Less: Interest 1,00,000 1,00,000 Less: Tax (50%) 50,000 EAT 50,000 No. of equity shares 10,000 EPS 5 a) Operating Leverage = +2202 _ 6 times 2,00,000 b) Financial Leverage ©) Combined Leverage =OLx FL=6x2=12 times eBIT &) Here ROI = opraremmroyea* 10° ROL = Om? x 100 = 10% 20,00,000 ) Operating Leverage = 6 AEBIT 6 028 AEBIT =4h15 4 Increase in EBIT = & 2,00,000 x 1.5 =€ 3,00,000 New BIT = 5,00,000 PROBLEM 4 From the following information extracted from the books of accounts of Imax Ltd., CALCULATE percentage change in earnings per share, if sales increase by 10% and Fixed Operating cost is € 1,57,500. Particulars ‘Amount in® EBIT (Earnings before Interest and Tax) 31,50,000 Earnings before Tax (EBT) 14,00,000 Solution: 1, Operating Leverage (DOL) Contribution _ EBIT + Fixed Cost ~EBIT EBIT 31,50,000www.myeduneeds.com Financial Leverage (DFL) _EBIT _ Rs. 31,50,000 _ EBT Rs. 14,00,000 Combined Leverage (DCL) = 1.05 x 2.25 = 2.3625 Percentage Change in Earnings per share % change in EPS % change in EPS - é = 2.3625 aa DCL Fe change in sales 10% + % change in EPS = 23.625% Henee, if sale is increased by 10%, EPS will be increased by 23.625%. PROBLEM 5 Consider the following information for Mega Ltd.: Production level 2,500 units Contribution per unit 150 Operating leverage 6 Combined leverage 24 Tax rate 30% Required: COMPUTE its earnings after tax. Solution: 1, Computation of Earnings after tax Contribution =F 150 x 2,500 = 3,75,000 Operating Leverage (DOL) x Financial Leverage (DFL) = Combined Leverage (DCL) 6 x Financial Leverage =24 « Financial Leverage =4 Operating Leve Contribution _ 3,75,000 _ perating Leverage Ep > 3,758,000 + EBIT = 62,500 Financial Leverage - EBT Since tax rate Earnings after Tax (EAT) = EBT (| — 0.30) [30% is tax rate] = 15,625 (0.70) + Earnings after Tax (EAT) =% 10,938www.myeduneeds.com PROBLEM 6 From the following information, prepare Income Statement of Company A & B: Particulars ‘Company A ‘Company B Marginal of safety 0.20 0.25 Interest % 3000 % 2000 Profit volume ratio 25% Financial Leverage 4 Tax rate 45% Solution: Income Statement Particulars ‘Company A ‘Company B Sales 80,000 36,000 Less: Variable Cost 60,000 24,000 Contribution 20,000 12,000 Less: Fixed Cost 16,000 9,000 EBIT 4,000 3,000 Less: Interest EBT 3,000 2,000 Tax (45%) 1,000 1,000 450 450 550 550 Working Notes: (i) Company A Financial Leverage =EBIT / (EBIT — Interest) 4 = EBIT / (EBIT - @ 3,000) 4EBIT -% 12,000 = EBIT 3 EBIT =% 12,000 EBIT =% 4,000 Company B Financial Leverage =EBIT / (EBIT — Interest) 3 = EBIT / (EBIT - & 2,000) 3EBIT-% 6000 =EBIT 2 EBIT =% 6,000 EBIT =%3,000 Gi) Company A Operating Leverage = 1/Margin of Safety = 1/0.20=5 Operating Leverage = Contribution / EBIT 5 =Contribution /% 4,000 Contribution = & 20,000 Company B Operating Leverage ~ 1/Margin of Safetywww.myeduneeds.com = 10.25=4 Operating Leverage = Contribution /EBIT 4 =Contribution /& 3,000 Contribution = 12,000 (iii) Company A Profit Volume Ratio = 25% (Given) Profit Volume Ratio = Contribution / Sales * 100 25% =® 20,000/Sales Sales =& 20,000/25% Sales = & 80,000 Company B Profit Volume Ratio = 33.33% Therefore, Sales =& 12,000 / 33.33% Sales =% 36,000 PROBLEM7 Betatronics Ltd. has the following Balance Sheet and Income Statement information: Balance Sheet as on March, 31" 2023 Liabilities &_ | Assets z Equity Capital © 10 per share)| 8,00,000 | Net Fixed Assets | 10,00,000 10% Debt 6,00,000 | Current Assets 9,00,000 Retained earnings 50,000 Current liabilities 1,50,000 19,00,000 19,00,000 Income Statement for the year ending March 31° 2023 Particulars x Sales 3,40,000 Operating expenses (including & 60,000 depreciation) 1,20,000, EBIT 2,20,000 Less: Interest Earnings before tax 60,000 Less: Taxes 1,60,000 Net Earnings (EAT) 56,000 1,04,000 a) DETERMINE the degree of operating, financial and combined leverages at the current sales level, if all operating expenses, other than depreciation, are variable costs. »b) If total assets remain at the same level, but sales (i) increase by 20 percent and (ii) decrease by 20 percent, COMPUTE the earings per share at the new sales level? Solution: a) Calculation of Degree of Operating (DOL), Financial (DFL) and Combined Leverages (DCL). 000 ~ 60,000 _ 2,20,000 127www.myeduneeds.com DCL =DOL x DFL = 1.27 x 1.38 = 1.75 ) Earnings per share at the new sales level Increase by 20% | Decrease by 20% i) ® Sales Level 4,08,000 2,72,000 Less: Variable expenses 72,000 48,000 Less: Fixed cost 60,000 60,000 Eamings before interest and taxes 2,76,000 1,64,000 Less; Interest 60,000 60,000 Earnings before taxes 2,16,000 1,04,000 Less: Taxes 75,600 36,400 Earnings after taxes (EAT) 1,40,400 67,600 Number of equity shares 80,000 80,000 EPS 1.76 | 0.85 Working Notes: (i) Variable Costs = 60,000 (total cost — depreciation) (i) Variable Costs at: (a) Sales level, & 4,08,000 = & 72,000 (increase by 20%) (b) Sales level, € 2,72,000 = % 48,000 (decrease by 20%) PROBLEM 8 A company had the following Balance Sheet as on 31% March, 2023: Liabilities in crores) Assets in crores) Equity Share Capital 3 (50 lakhs shares of € 10 each) Reserves and Surplus 1 | Fixed Assets (Net) 125 15% Debentures 10 | Current Assets 15 Current Liabilities 4 20 20 The additional information given is as under: Fixed cost per annum (excluding interest) 4 crores Variable operating cost ratio 65% ‘Total assets turnover ratio 25 Income Tax rate 30% Required: (@ — Eamings Per Share Gi) Operating Leverage Gi) Financial Leverage (iv) Combined Leveragewww.myeduneeds.com Solution: Total Assets =%20 Total Asset Tumover Ratio =25 Hence, Total Sales = 20x 2.5 =€ 50 Crores Computation of Profit After Tax (PAT) ‘in Crores) Sales 50.00 Less: Variable Operating Cost @ 65% 32.50 Contribution 17.50 Less: Fixed Cost (other than interest) 4.00 EBIT 13.50 Less: Interest on Debentures (15% x 10) 1.50 PBT 12.00 Less: Tax @ 3.60 PAT 8.40 (i) Earnings per Share: EPs 8.40 Crores 840.CroFes 216 59 “Number of Equity Shares —_50,00,000 It indicates the amount the company ears per share. Investors use this as a guide while valuing the share and making investment decisions. Itis also a indicator used in comparing firms within an industry or industry segment. Gi) Operating Leverage Contribution _ 17.50 _ | 594 Operating Leverage cur wae0 It indicates the choice of technology and fixed cost in cost structure. It is level specific. When firm operates beyond operating break — even level, then operating leverage is low. It indicates sensitivity of earnings before interest and tax (EBIT) to change in sales at a particular level. (iii) Financial Leverage: Financial Leverage = The financial leverage is very comfortable since the debt service obligation is small vis - a— vis EBIT. (iv) Combined Leverage: Contribution _ EBIT OR, Combined Leverage = C0", SRT EBIT PBT = Operating Leverage x Financial Leverage = 1.296 x 1.125 = 1.458 The combined leverage studies the choice of fixed cost in cost structure and choice of debt in capital structure. It studies how sensitive the change in EPS is vis — a — vis change in sales. The leverages operating, financial and combined are used as measurement of riskwww.myeduneeds.com PROBLEM 9 ‘The following information is related to YZ company Ltd. Equity share capital (& 10 each) 12% Bonds ®1000 each) Sales Fixed cost (excluding interest) Financial leverage PV ratio Income tax rate You are required to calculate: (Operating leverage (ii) Combined leverage (iii) Earnings per share Show up the calculations up-to 2 decimal points. Solution Computation of PAT For the year ended 31st March 2023 % 50 lakhs 37 lakhs 84 Lakhs % 6,96 Lakhs 1.49 times. 27.55% 40% Particulars ‘Amount ®@) Sales 84,00,000 Contribution (Sales x PV Ratio) 23,14,200 Less: Fixed Cost (excluding interest) 6,96,000 EBIT 16,18,200 Less: Interest on Debentures (37 lakhs x 1 4,44,000 Less: Other interest (balancing figure) 88,160 EBT 10,86,040 Less: tax @ 40% EAT EPS = EAT /no. of Shares Operating Leverage = Contribution / EBIT = 23,14,200 / 16,18,200 = 1.43 times Combined leverage = DOL x DFL =143x 149 = 2.13 times DFL. =EBIT/EBT 149 = 16,18,200 / EBT EBT = 10,86,040 /-www.myeduneeds.com PROBLEM 10 ‘The following information is available for SS Ltd. Profit volume (PV) ratio - 30% Operating leverage = 2.00 Financial leverage = 1.50 Loan -%1,25,000 Post-tax interest rate - 5.6% Tax rate - 30% ‘Market Price per share (MPS) -%140 Price Barnings Ratio (PER) -10 You are required to (a) Prepare the Profit-Loss statement of S Ltd. and (b) Find out the number of equity shares. Solution: Post — tax interest = 5.6% 56 _ 56 + Pre —tax interest, = = 28-38% re — tax interest aon a7 8% + Interest Amount = Loan x 8% = 125000 x 8% = 10,000 DEL = —— sr EBIT- INTEREST 15 + 1S EBIT - 15000 + 0.5 EBIT + EBIT Contribution DOL “ee Contribution 2— SOREIDUTCR .. Contribution ~ 30,000 x 2~ 60,000/- 30,000 1 PIV Ratio = SORUIBULOR 594, - $0.000 ates = 200,000/- sales saleswww.myeduneeds.com Sr. No. Particulars Amount @) A Sales 200,000 B Variable Cost (Balancing figure) 140,000" C Contribution 60,000 D Fixed Cost (Balancing figure) 30,000 E EBIT 30,000 F Interest 10,000 G T 20,000 i Tax @ 30% 5,000 I EAT or NI 14,000 I EPS 14 K PIE Ratio 10 L MPS (x K) 140 M_[No. ofshare d=) 1000 shares PROBLEM 11 Debu Ltd. currently has an equity share capital of € 1,30,00,000 consisting of 13,00,000 Equity shares. The company is going through a major expansion plan requiring to raise funds to the tune of & 78,00,000. To finance the expansion the management has following plans: Plan-I ; Issue 7,80,000 Equity shares of € 10 cach. Plan-II : Issue 5,20,000 Equity shares of € 10 each and the balance through long-term borrowing at 12% interest p.a Plan-III : Issue 3,90,000 Equity shares of 10 each and 39,000, 9% Debentures of % 100 each. Plan-IV : Issue 3,90,000 Equity shares of & 10 each and the balance through 6% preference shares. EBIT of the company is expected to be € 52,00,000 p.a. Considering corporate tax rate @ 40%, you are required to- (i) CALCULATE EPS in each of the above plans. (ii) ASCERTAIN financial leverage in each plan and comment. Solution: Sources of Capital Plant Plan Plan TI Plan IV Present Equity Shares 13,00,000 13,00,000 | _13,00,000[ _13,00,000 New Issue 7,80,000 5,20,000 3,90,000 3,90,000 Equity share capital @) 2,08,00,000 | _1,82,00,000 | _1,69,00,000| _1,69,00,000 No. of Equity shares 20,80,000 18,20,000 | 16,90,000| _16,90,000 12% Long term loan @) 5 26,00,000 : = 9% Debentures @) - =| 39,00,000 = (6% Preference Shares @) - = =[__39,00,000www.myeduneeds.com Computation of EPS and Financial Leverage Sources of Capital Plan I Plan | Plant | Plan Iv EBIT @) 52,00,000 | 52,00,000 | _52,00,000 | 52,00,000 Less: Interest on 12% Loan (®) =| 3,12,000 = = Less: Interest on 9% debentures @) - = [351,000 : EBT @) 52,00,000 | 48,88,000 | _48,49,000 | 52,00,000 Less: Tax@ 40% 20,80,000 | 19,55,200 | _19,39,600 | 20,80,000 FAT ® 31,20,000 | _29,32,800 | _29,09,400 [_31,20,000 Less: Preference Dividends @) - = =| _2,34,000 (@)_Net Farnings available for equity shares @) | _31,20,000[ 29,32,800 | 29,09,400 | 28,86,000 (b) No. of equity shares 20,80,000 | 18,20,000 | 16,90,000 | 16,90,000 © _EPS@=H@ 150 161 172 V7 Financial leverage EBIT) = 1.00 1.06 107 108 EBT f EBIT. * Financial Leverage in the case of Preference dividend = (pp) (EBIT-INTEREST)=—P>, 52,00,000 52,00,000, ) =¢ )= 1.08 (52,00,000 48,10,000 =04)) PROBLEM 12 ‘The following information is related to Navya Company Ltd, for the year ended 31% March 2023 iquity share capital (10 each) &65,50,000 12% Bonds of € 1,00 each %60,91,400 Sales @111 lakhs: Fixed cost (excluding interest) & 715,000 Financial leverage 135 Profit-volume Ratio 235% Tncome Tax Applicable 30% You are required to CALCULATE: Operating Leverage. Combined leverage; and Earnings per share, Show calculations upto two decimal points. Solution: a) Income Statement Particulars ‘Amount @) Sales 1,11,00,000 Contribution (Sales «P/V ratio) 27,75,000 Less: Fixed cost (excluding Interest) (715,000) EBIT (Earnings before interest and tax) 20,60,000 Less: Interest on debentures (12% x € 60,91,400) (730,968) EBT (Earnings before tax) 13,29,032 Less: Tax @ 30% 398,710 PAT (Profit after tax)www.myeduneeds.com (i) Operating Leverage: _Contribution _ Rs.27,75,000 _ a = 135 EBIT Rs.20,60,000 (ii) Combined Leverage: = Operating Leverage x Financial Leverage = 1.35 x 1.55 = 2.09 (Approx) Or, Contribution Contribution EBIT Combined Leverage Or Contribution _ Rs.20,60,000 Combined Leverage = —S>UEOR = ESE = 2.09 (Approx) EBIT Rs.13,29,032 (iii) Earnings per share (EPS): PAT Rs.9,30,322 ooFsnanes guiStanding = @e5b00 cau haweg 7% 142 Nowfshares outstanding 655,000 equity shares PROBLEM 13 Following information is provided relating to SVB Ltd. Sales price 21 per unit Variable cost 13.50 per unit Break-even point 30,000 units ‘You are required to CALCULATE operating leverage at sales volume 37,500 units and 45,000 units. Solution: Computation of Operating Leverage (OL) Selling Price =€ 21 per unit Variable Cost = 13.50 per unit Fixed Cost = BEP x (Selling price — Variable cost) = 30,000 (21 - 13.50) 30,000 x 7.5 = 2,25,000 Particulars For 37,500 units @) | For 45,000 units @ Sales (@ ¥21 /unit) 787,500 9,45,000 Less: Variable Cost (@ 13.50 /unit) 5,06,250 6,07,500 Contribution 281,250 337) Less: Fixed Cost 2,25,000 2,25,000 Earnings before Interest and tax (EBIT) 36,250 1,12,500 Contribution Operating Leverage (Paton) eS Operating Leverage S times timeswww.myeduneeds.com CHAPTER 3 FINANCING DECISIONS - CAPITAL STRUCTURE PROBLEM 1 Rupa Ltd.'s EBIT is € 5,00,000, The company has 10%, € 20 lakh debentures. The equity capitalization rate ie. Ke is 16%, You are required to CALCULATE: (i) Market value of equity and value of firm (i) Overall cost of capital. Solution: (i) Statement showing value of firm z EBIT 5,00,000 Tess: Interest on debentures (10% of € 20,00,0000 2,00,000) Earnings available for equity holders ie. Net Income (NI) 3,00,000 Equity capitalization rate (Ke) 16% sivalue _NT_ 300,000 18,73,000 Market value of equity (S)= f= "277° 100 Market value of debt (D) 20,00,000 Total value of firm V=S+D 38,75,000 EBIT 5,004 (ii) Overall cost of capital = —S2P = 5.200.000 _ 15 goo, Value offirm — 38,753,000 PROBLEM 2 Indra Ltd, has EBIT of & 1,00,000. The company makes use of debt and equity capital. The firm has 10% debentures of & 5,00,000 and the firm’s equity capitalization rate is 15%, ‘You are required to COMPUTE: (i) Current value of the firm (Gi) Overall cost of capital Solution () Calculation of total value of the firm z EBIT 1,00,000 Less: Interest (@ 10% on & 5,00,000) 50,000 Earnings available for equity holders 50,000 Equity capitalization rate i.e. Ke 15% Earnings available for equity holders Value of equity holders = 7S Value of equi =%3,33,333 045 Value of Debt (given) D 5,00,000 Total Value of the firm V =D + $ (5,00,000 + 3,3: 3 83www.myeduneeds.com Gi) Overall cost of capital = Ko =Ke 5+Ky 2 or ST viKay v 333,393 5,00,000 -o.s | 833,333, 333333, - [50,000 + 50,000] = 12.00% 833,333 PROBLEM 3 DETERMINE the optimal capital structure of a company from the following information: Options] Cost of Debt (Ka) | Cost of Equity (Ke) | Percentage of Debt on total value in % in % (Debt + Equity) 1 1 13.0 00 2 u 13.0 oO 3 116 140 02 4 12.0 15.0 03 5 13.0 16.0 04 6 15.0 18.0 05 1 18.0 20.0 06 Solutio Note that the ratio given in this question is not debt to equity ratio, Rather it is the debt to value ratio. Therefore, if the ratio is 0.6, it means that capital employed comprises 60% debt and 40% equity. KdxD+Kexs D4S In this question total of weight is equal to 1 in all cases, hence we need not to divide by it. 1) Ko=11%x0+ 13%x1=13% 2) Ko= 11% x 0.1 + 13% x 0.9 = 12.8% 3) Ko= 11.6% x 0.2 + 14% x 0.8 = 13.52% 4) Ko= 12% x 0.3 + 15% x 0.7= 14.1% 5) Ko= 13% x 0.4 + 16% x 0.6 = 14.8% 6) Ko= 15% x 0.5 + 18% x 0.5 = 16.5% 7) Ko= 18% x 0.6 + 20% x 0.4 = 18.8% Decision: 2" option is the best because it has lowest WA\ PROBLEM 4 Amita Ltd.'s operating income (EBIT) is € 5,00,000. The firm’s cost of debt is 10% and currently the firm employs & 15,00,000 of debt. The overall cost of capital of the firm is 15%, You are required to CALCULATE: (i) Total value of the firm. (ii) Cost of equity.www.myeduneeds.com Solutio (@ Statement showing value of the firm z Net opening income / EBIT 5,00,000 Less: Interest on debentures (10% of € 15,00,000) (1,50,000) Earnings available for equity holders 3,50,000 Total cost of capital (Ko) (given) 15% EBIT _ 5,00,000 333 Value of the firm V = scnene 33,33,33 Ko 045 @ Calculation of cost of equity = Market value of debt (D) 15,00,000 Market value of equity (s) S = V - D = % 33,33,333 - € 15,00,000 18,33,333 Earnings available for equity holders Value of equity (S) = Interest paid on debt, or, Market Value ofequty 033333” 19-09% OR Sie D -K, 5+Ky2 Ke Ke v Ka v vy TK Kg 33,33,333 415,00,000 0s [Fpsaasal “0 seazass —_ 3 Toas,333 [0-15 x 33,33,333) — (0.10 x 15,00,000)] —+ _ [5,00,000 — 1,50,000] = 19.09% 7033.38 PROBLEM 5 Alpha Limited and Beta Limited are identical except for capital structures. Alpha Ltd. has 50 per cent debt and 50 per cent equity, whereas Beta Ltd. has 20 per cent debt and 80 per cent equity. (All percentages are in market — value terms). The borrowing rate for both companies is 8 per cent in a no — tax world, and capital markets are assumed to be perfect. (a) @) If you own 2 per cent of the share of Alpha Ltd., DETERMINE your return if the company has net operating income of € 3,60,000 and the overall capitalization rate of the company, Ko is 18 per cent? (ii) CALCULATE the implied required rate of return on equity? (b) Beta Ltd. has the same net operating income as Alpha Ltd. (i) DETERMINE the implied required equity return of Beta Ltd.? (ji) ANALYSIS why does it differ from that of Alpha Ltd.? Solution: a) Value of the Alpha Ltd, =F 20,00,000www.myeduneeds.com (i) Return on Shares on Alpha Ltd. z Value of the company 20,00,000 Market value of debt (50% 10,00,000 Market value of shares (50%) 10,00,000 z Net operating income 3,60,000 Interest on debt (8% x & 10,00,000) 80,000 Earnings available to shareholders 2,80,000 Return on 2% shares (2% x & 2,80,000) 5,600 Gi) Implied required rate of return on equity = FT oo5 b) (i) calculation of Implied rate of return ze Total value of company 20,00,000 Market value of debt (20% x & 20,00,000) 4,00,000 Market value of equity (80% x & 20,00,000) 16,00,000 z Net operating income 3,60,000 Interest on debt (8% x & 4,00,000) 32,000 Earnings available to shareholders |__3,28,000 - _ 328,000 5 gy, Implied required rate of retum on equity = [>= 20.5% (ii) It is lower than the Alpha Ltd. because Beta Ltd. uses less debt in its capital structure. As the equity capitalization is a linear function of the debt ~ to — equity ratio when we use the net operating income approach, the decline in required equity return offsets exactly the disadvantage of not employing so much in the way of ‘cheaper’ debt funds. PROBLEM 6: ‘When value of levered firm is more than the value of unlevered firm There are two company N Ltd. and M Ltd., having same earnings before interest and taxes i.e. EBIT of & 20,000. M Ltd. is a levered company having a debt of & 1,00,000 @ 7% rate of interest. The cost of equity of N Ltd. is 10% and of M Ltd. is 11.50%. COMPUTE how arbitrage process will be carried on? Solution: (Company M Ltd. NLtd. EBIT (NOD, 20,000 20,000 Debt (D) %1,00,000 = K 11.50% 10% Ka 7% =www.myeduneeds.com Value of equity (S _ NoI-Interest alue of equity (8) =O Feguiny Sy = R000 113,043 11.50% 20,000 5, Sw vam 7% 2,00,000 Var =1,13,043 + 1,00,000 (V = $ + D) =€ 2,13,043, Vw = 2,00,000 Arbitration process: Amount received by sell of 10% shares in M Ltd. (1,13,043 x 10%) 11,304 Personal borrowing (1,00,000 x 10%) 10,000 Total amount available for investment 21,304 Purchase of 10% shares in N Ltd. (2,00,000 x 10%) 20,000 Therefore surplus cash available 1.304 Position of investor in both the companies company M Ltd. Nita. EBIT (NON, 20,000 20,000 Less: Interest (100,000 x 7%) 7,000 = ‘Net Income 13,000 20,000 Dividend receivable for shareholder 1,300 2,000 Less: Personal borrowing Interest (10,000 x 7%) = 700 Net Income available for investor 1,300 1,300 Conclusion: Thus, investor will switch his holding from M Ltd. to N Ltd. PROBLEM 7: Invest entire amount and get extra income, Following data is available in respect of two companies having same business risk: Capital employed = 2,00,000, EBIT = % 30,000 Ke= 12.5% Sources Levered Company ®) | _Unlevered Company ®) Debt (@ 10%) 1,00,000 Nil Equity 1,00,000 2,00,000 Investor is holding 15% shares in levered company. CALCULATE increase in annual earnings of investor if he switches his holding from Levered to Unlevered company.www.myeduneeds.com Solution: 1. Valuation of firms Particulars EBIT Less: interest Earnings available to Equity Shareholder (ND) Ke Value of Equity (S) = NI/ Ke Debt Value of Firm ($ + D) | _Levered Firm @) | Unlevered Firm @) 30,000 30,000 10,000 Nil 20,000 30,000 12.5% 12.5% 160,000 2,40,000 1,00,000 Nil 2,60,000 2,40,000 Value of Levered company is more than that of unlevered company. Therefore investor will sell his shares in levered company and buy shares in unlevered company. To maintain the level of risk he will borrow proportionate amount and invest that amount also in shares of unlevered company, 2. Investment & Borrowings Sell shares in Levered company (1,60,000 x 15%) 24,000 Borrow money (1,00,000 x 15%) 15,000 Amount available for investment in shares of Unlevered company 39,000 3. Change in Return Income from shares in Unlevered company (39,000 x 12.5%) 4875 Less: interest on loan (15,000 x 10%) 1,500 Net Income from unlevered firm 3.375 Income from Levered firm (24000 x 12.5%) 3,000 Incremental Income due to arbitrage 315 PROBLEM 8: When value of unlevered firm is more than the value of levered firm, ‘There are two companies U Ltd. and L Ltd., having same NOI of € 20,000 except that L Lid. is a levered company having a debt of € 1,00,000 @ 7% and cost of equity of U Ltd. & L Ltd. are 10% and 18% respectively. COMPUTE how arbitrage process will work. Solution: Particulars ‘Company U Ltd. L Ltd. NOL = 20,000 % 20,000 Debt Capital _ = 1,00,000 Ka _ ™% Ke 10% 18% Valeo equity capital) = 2TH 2.00.00 tn22 20,000 20,000 -7,000 0.0 078 Total value of the firm =S+D % 2,00,000 | & 1,72,222 (& 72,222 +& 1,00,000)www.myeduneeds.com Assume you have 10% shares of unlevered firm i.e. investment of 10% o & 2,00,000 = & 20,000 and Return @ 10% on & 20,000. Investment will be 10% of earnings available for equity i.e. 10% x 20,000 = & 2,000. Alternative strategy: Sell your shares in unlevered firm 20,000 and buy 10% shares of levered firm’s equity plus debt i.e. 10% equity of levered firm = 7,222 10% debt to levered firm = 10,000 Total investment = 17,222 ‘Your resources are € 20,000 ‘Surplus cash available = Surplus ~ Investment = 20,000 — 17,222 =€ 2,778 ‘Your return on investment is: 7% on debt of € 10,000 700 10% on equity i.e. 10% of earnings available for equity holders i.e. (10% x 13,000) 1,300 Total return 2,000 i.e. in both the cases the retum received is € 2,000 and still you have excess cash of € 2,778. Hence, you are better off i.e. you will start selling unlevered company shares and buy levered company’s shares thereby pushing down the value of shares of unlevered firm and inereasing the value of levered firm till equilibrium is reached. In the above example we have not invested entire amount received from “sale of shares of Unlevered company”. We also have the same level of earning along with reduced investment. Alternatively, we could have invested entire amount in Levered company. In that case annual earnings would have increased. An example for the same is as follows: PROBLEM 9 Following data is available in respect of two companies having same business risk: Capital employed = 2,00,000, EBIT = 30,000 ‘Sources ‘Levered Company @®) | _Unlevered Company @) Debt (@ 10%) 1,00,000 Nil Equity 1,00,000 2,00,000 Ke 20% 12.5% Investor is holding 15% shares in Unlevered company, CALCULATE increase in annual earnings of investor if he switches his holding from Unlevered to Levered Company. Solution: 1. Valuation of firms Particulars Levered Firm @)| Unlevered Firm @) EBIT 30,000 30,000 Less: interest 10,000 Nil Earnings available to Equity Shareholder 20,000 30,000 Ke 20% 12.5% Value of Equity 100,000 2,40,000 Debt 100,000 Nil Value of Firm 2,00,000 240,000www.myeduneeds.com Value of Unlevered Company is more than that of Levered company therefore investor will sell his shares in unlevered company and buy shares in levered company. Market value of Debt and Equity of Levered company are in the ratio of & 1,00,000: & 1,00,000, i.e., 1:1. To maintain the level of risk he will lend proportionate amount (50%) and invest balance amount (50%) in shares of Levered company. 2, Investment & Borrowings z Sell shares in Unlevered company (240000 x 15%) 36,000 Lend money (36000 x 50%) 18,000 Buy shares in Levered company (36,000 x 50%) 18,000 Total 36,000 3. Change in Return z Income from shares in Levered company (18000 x 20%) 3,600 Interest on money lent (18000 x 10%) 1,800 Total Income after switch over 5,400 Income from Unlevered firm (36,000 x 12.5%) 4,500 Incremental Income due to arbitrage 900 PROBLEM 10 Best of Luck Ltd., a profit making company, has a paid — up capital of € 100 lakhs consisting of 10 lakhs ordinary shares of € 10 each. Currently, it is earning an annual pre — tax profit of € 60 lakhs. The company’s shares are listed and are quoted in the range of & 50 to & 80, The management wants to diversify production and has approved a project which will cost ® 50 lakhs and which is expected to yield to pre - tax in come of & 40 lakhs per annum. To raise this additional capital, the following options are under consideration of the ‘management, (2) To issue equity share capital for the entire additional amount. Itis expected that the new shares (face value of & 10) can be sold at a premium of & 15 (b) To issue 16% non — convertible debentures of € 100 each for the entire amount, (c) To issue equity capital for % 25 lakhs (face value of % 10) and 16% non — convertible debentures for the balance amount, In this ease, the company can issue shares at a premium of 40 each, CALCULATE the additional capital that can be raised, keeping in mind that the management wants to maximize the earnings per share to maintain its goodwill. The company is paying income tax at 50%. Solution: Calculation of Earnings per share under the three options: Particulars Options Option I: Issue Equity shares Option Ii: Issue 16% Debentures Option III: Issue Equity Shares an only only 16% Debentures of equal amount ‘Number of Equity Shares (Nos): - Existing 10,00,000 10,00,000 10,00,000 - Newly issued 2,00,000 _ 50,000 Rs, 50,00,000 Rs, 25,00,000 Gaaoriey) Cra abea0 Total 12,00,000 10,00,000 10,50,000www.myeduneeds.com 16% Debentures © = 50,00,000 25,00,000 Profit Before Interest and Tax: - Existing pre — tax profit 60,00,000 60,00,000 60,00,000 - From new projects 40,00,000 40,00,000 40,00,000 1,00,00,000 1,00,00,000 1,00,00,000 Less: Interest on 16% Debentures _ 8,00,000 4,00,000 (16% on F 50,00,000) | (16% on € 25,00,000) Profit Before Tax 1,00,00,000 92,00,000 96,00,000 Tax at 50% '50,00,000 46,00,000 48,00,000 Profit After Tax 50,00,000 46,00,000 48,00,000 Earnings Per Share (EPS) 417 PAT Rs.50,00,000 PROBLEM 12 Tata Ltd. is considering two alternative financing plans as follows: Particulars Plan-A®)| Plan—B ®) Equity shares of € 10 each 8,00,000 8,00,000 Preference shares of € 100 each _ 4,00,000 12% Debentures 4,00,000 _ 12,00,000 12,00,000 ‘The indifference point between the plans is 4,80,000. Corporate tax rate is 30%. CALCULATE the rate of dividend on preference shares. Solution: Computation of Rate of Preference Dividend interest) (1 -t) = EBIT(1-t)- Preference Dividend No.of Equity Shares (N,) No.of Equity Shares (Nz) (4,80,000 ~ 48,000) x (1 - 0.30) = 4,80,000 (1 - 0.30) - Preference Dividend 180,000 Shares ‘80,000 Shares 302,400 = 3,36,000~ Preference Dividend {80,000 shares ‘80,000 shares &3,02,400 = %3,36,000 — Preference Dividend Preference Dividend = %3,36,000 -% 3,02,400 =F 33,600 Rate of Dividend = _Preference Dividend, Preference share capital = 33,600 » Fo0,000 * 100 = 8.4% PROBLEM 13 One - third of the total market value of Sanghmani Limited consists of loan stock, which has a cost of 10 per cent. Another company, Samsui Limited, is identical in every respect to Sanghmani Limited, except that its capital structure is all — equity, and its cost of equity is 16 per cent. According to Modigliani and Miller, if we ignored taxation and tax relief on debt capital, COMPUTE the cost of equity of Sanghmani Limited?www.myeduneeds.com Solution: Here we are assuming that MM Approach 1958: Without tax, where capital structure has no relevance with the value of company and accordingly overall cost of capital of both levered as well as unlevered company is same. Therefore, the two companies should have similar WACCs, Because Samsui Limited is all — equity financed, i.e. 16 per cent. It follows that Sanghmani Limited should have WACC equal to 16 per cent also. ‘Therefore, Cost of equity in Sanghmani Ltd. (levered company) will be calculated a follows: Ko~2xKe+ 2 x Ka= 16% (ie. equal to WACC of Samsui Ltd.) Or, 16% =2xKet tx 10% Or, Ke = 19% PROBLEM 14 ABC Limited provides you the following information ® Profit (EBIT) 2,380,000 Less: Interest on Debt @10% 40,000 EBT 240,000 Less: Income Tax @ 50% 1,20,000 1,20,000 No. of Equity Shares (€ 10 each) 30,000 Zarnings per share (EPS) 4 Price / EPS (P/E) Ratio 10 Ruling Market price per share 40 The company has undistributed reserves of & 7,00,000 and needs & 4,00,000 further for expansion. This investment is expected to eam the same rate as finds already invested. You are informed that a debt equity (debt debt +equity) ratio higher than 32% will push the P/E ratio down to 8 and raise the interest rate on additional borrowings (debentures) to 12%. You are required to ASCERTAIN the probable price of the share, (i) If the additional funds are raised as debt; and (i) Ifthe amount is raised by issuing equity shares at ruling market price of € 40 per share. Solution: Ascertainment of probable price of shares Particulars Plan Plan (i) (IfF 4,00,000is | (fF 4,00,000 is raised as debt) | raised by issuing ® equity shares) ) Earnings Before Interest (EBIT) 20% on (14,00,000 + 4,00,000) 3,60,000 3,60,000 Less: Interest on old debentures @ 10% on 4,00,000 40,000 40,000 3,20,000 3,20,000 Less: Interest on New debt @ 12% on & 4,00,000 48,000 = Earnings Before Tax (After interest) 2,72,000 3,20,000 Less: 1,36,000 1,60,000 Earnings for equity shareholders (EAT) 7,36,000 1,60,000 ‘Number of Equity Shares (in numbers) 30,000 40,000www.myeduneeds.com Earnings per Share (EPS) 4.53 4.00 Price/ Earnings Ratio 8 10 Probable Price Per Share 36.24 (8 x 4.53) 40 (10x 4) Working Notes: ® 1, Calculation of Present Rate of Eamings ity Share capital (30,000 x & 10) 3,00,000 00 10% Debentures (40,000 x °) 4,00,000 Reserves (given) 7,00,000 14,00,000 Earnings before interest and tax (EBIT) given 2,80,000 ate esent Earnings = (22000 20% Rate of Present Earnings = (==, x 100) 700,000 2, Number of Equity Shares to be issued in Plan (“°°°* ) 10,000 Thus, after the issue total number of shares. 30,000 + 10,000 = 40,000 3. Debt/Equity Ratio if & 4,00,000 is raised as debt: BOO 100) 44.44% 00,000 As the debt equity ratio is more than 32% the P/E ratio shall be 8 in plan (i) PROBLEM 15 Leo Ltd. has a net operating income of € 21,60,000 and the total capitalisation of € 120 lakhs. The company is evaluating the options to introduce debt financing in the capital structure and the following information is available at various levels of debt value. Debt value @)_| Interest rate (%) | Equity Capitalisation rate (%) 0 NA. 12.00 10,00,000 7.00 12.50 20,00,000 7.00 13.00 30,00,000 7.50 13.50 40,00,000 7.50 14.00 50,00,000 8.00 15.00 60,00,000 8.50 16.00 70,00,000 9.00 17.00 80,00,000 10.00 20.00 You are required to COMPUTE the equity capitalization rate if MM approach is followed. Assume that the firm operates in zero tax regime and calculations to be based on book values. Solution: As per MM approach, cost of the capital (K.) remains constant, and cost of equity increases linearly with debt. Value of a Firm = 52 Ke 21,60,000 1,20,00,000 = 2"www.myeduneeds.com 21,60,000 Ky == = 18% 120,00,000 ‘Under MM approach, ke = ky +2 (ko ~ ku) Statement of equity capitalization under MM approach Debt Value | Equity Value | Debt/ Ka Ko(%) | Ko-Ka Ke = Ko+(Ko-Ka) (D/E) ® ® Equity | (%) (hy (%) - 1,20,00,000 0.0000 NA 18.00 18.00 18.00 10,00,000 | 1,10,00,000 0.0909 7.00 18.00, 11.00 19.00 20,00,000 1,00,00,000 0.2000 7.00 18.00 11.00 20.20 30,00,000 90,00,000 0.3333, 7.50 18.00, 10.50 21.50 40,00,000 80,00,000 0.5000 7.50 18.00 10.50 23.25 50,00,000 70,00,000 0.7143 8.00 18.00 | 10.00 25.14 60,00,000 60,00,000 1,0000 8.50, 18.00 9.50 27.50 70,00,000 50,00,000 1.4000, 9.00 18.00 9.00 30.60 80,00,000 40,00,000 2.0000 10.00 18.00 8.00 34.00 PROBLEM 16 ‘The financial advisor of Sun Ltd. is confronted with following two altemative financing plans for raising 10 lakhs that is needed for plant expansion and modemization Alternative I: Issue 80% of funds with 14% Debenture [Face value (FV) & 100] at par and redeem at a premium of 10% after 10 years and balance by issuing equity shares at 33 +% premium. Alternative IT: Raise 10% of funds required by issuing 8% Irredeemable Debentures [Face value (FV) = 100] at par and the remaining by issuing equity shares at current market price of & 125. Currently, the firm has an Earnings per share (EPS) of € 21 ‘The modernization and expansion programme is expected to increase the firm’s Earnings before Interest and Taxation (EBIT) by % 200,000 annually. ‘The firm's condensed Balance Sheet for the current year is given below: Balance Sheet as on 31.3.2022 Liabi ®@ “Assets @ Current Liabilities 5,00,000 | Current Assets 16,00,000 10% Long Term Loan 15,00,000 | Plant & Equipment (Net) 34,00,000 Reserves & Surplus 10,00,000 Equity Share Capital (FV: % 100 each) | _20,00,000 TOTAL 30,00,000 TOTAL 30,00,000 However, the finance advisor is concemed about the effect that issuing of debt might have on the firm, The average debt ratio for firms in industry is 35%. He believes if this ratio is exceeded, the P/E ratio of the company will be 7 because of the potentially greater risk If the firm increases its equity capital by more than 10 %, he expects the P/E ratio of the company will increase to 8.5 irrespective of the debt ratio. Assume Tax Rate of 25%. Assume target dividend pay-out under each alternative to be 60% for the next year and growth rate to be 10% for the purpose of calculating Cost of Equity.www.myeduneeds.com SUGGEST with reason which alternative is better on the basis of each of the below given criteria: I. Earnings per share (EPS) & Market Price per share (MPS) II. Financial Leverage III Weighted Average Cost of Capital & Marginal Cost of Capital (using Book Value weights) Solution: Calculation of Equity Share capital and Reserves and surplus: Alternative 1 852.00.000%100 _ 91 59,999 133.3393, _ 5 2,00,000x33.3333, Reserves = & 10,00,000 + S222 SESS —& 10,50,000 Equity Share capital = 20,00,000 + Alternative 2: Equity Share capital = & 20,00,000 + 5£220:200% 100 _ & 97 99,090 =% 11,80,000 s9,00,000x 25 Reserves =@ 10,00,000 + Capital Structure Plans (Amount in 8) Capital Alternative I Alternative 2 z z Equity Share capital 21,50,000 27,20,000 Reserves and surplus 10,50,000 11,80,000 10% Tong term debt 15,00,000 15,00,000 14% Debentures 8,00,000 = 8% Irredeemable Debentures 1,00,000 Total Capital Employed 55,00,000 35,00,000 Computation of Present Earnings before interest and tax (EBIT) EPS @) 21 No. of equity shares 20,000 Earnings for equity shareholders (1x 1) ®@) 20,000 Profit Before Tax (II1/75%) ®@) 5,60,000 Interest on long term loan (1500000 x 10%) ®) 1,50,000 EBIT (V+V) @ 7,10,000 EBIT after expansion = 7,10,000 + 2,00,000 = 9,10,000 Evaluation of Financial Plans on the basis of EPS, MPS and Financial Leverage (Amount in 3) Particulars Alternative I ‘Alternate IT EBIT 9,10,000 910,000 Less: Interest: 10% on long term loan (150,000) (50,000) 14% on Debentures (112,000) Nil 8% on Irredeemable Debentures Nil. (8000) PBT 648,000 752,000 Less: Tax @25% (62,000) (88,000) PAT. 4,86,000 5,64,000www.myeduneeds.com No. of equity shares 21,500 27,200 EPS 22.60 20.74 Applicable P/E ratio (Working Note 1) 7 85 MPS (EPS X PIE ratio) 158.2 176.29 Financial Leverage EBIT/PBT 1.40 121 Working Note 1 Alternative I Alternative 1 Debt: &15,00,000 + & 8,00,000 23,00,000 = &15,00,000 + & 1,00,000 = 16,00,000 Total capital Employed @) 55,00,000 35,00,000 Debt Ratio (Debt/Capital employed) = 0.4182 = 0.2909 = 41.82% = 29.09% Change in Equity: & 21,50,000 - € 20,00,000 1,50,000 7,20,000 % 27,20,000 -& 20,00,000 Percentage change in equity 75% 36% ‘Applicable P 7 85 Calculation of Cost of equity and various type of debt Alternative I Alternative I A) Cost of equity EPS@ 22.60 20.74 DPS (EPS X 60%) & 13.56 1244 Growth () 10% 10% Po (MPS) 158.2 176.29 Ke Do(I=g)/ Po TSEC — 9 4305 RMON _7 76%, B) Cost of Debt: 10% Tong term debt 10% + (1-023) 10% + (1-025) =15% =75% 14% redeemable debentures HGH ENO, nil 105+ 1/105 0.95% 8% irredeemable debenture NA) 8000 (1-0.25)/1,00,00 = 6% Calculation of Weighted Average cost of capital (WACC) Alternative 1 Alternative 2 Capital Weights | Cost (%_WACC |" Weights | Cost(%) | WACC Equity Share Capital 03909[ 9.43 | __3.69% 0.4945 7.76 | 3.84% Reserves and Surplus 0.1909 | 9.43 | _1.80% 02145 776 [1.66% 10% Long term Debt 0.2727 7.50 2.05% 0.2727 7.50 2.05% 14% Debenture 01455] 1095 | 1.59% 8% Irredeemable Debentures - 0.0182 6 0.11% 9.12% 7.66%www.myeduneeds.com Calculation Marginal Cost of Capital (MACC) Alternative 1 Alternative 2 Capital (weight | Cost (%)| MACC| (weight) | Cost (%)|_MACC Equity Share Capital %7,50,000 %7,20,000 (0.15) 9.43 | 141% (0.72) 1.16 | 5.59% Reserves and Surplus %50,000 &7,80,000 (0.05) 9.43 | 0.47% (0.18) 1.76| 1.40% 14% %8,00,000 10.9 Debenture (0.80) 5 8.76% - 0.00% 8% = 1,00,000 Irredeemable Debentures, : (0.10) 6) 0.60% Total Capital Employed %10,00,000 10.65% | & 10,00,000 758% Summary Solution: Alternate I Alternate IL Earning per share (EPS) & 22.60 20.74 Market Price per share (MPS) & 158.20 176.29 Financial leverage 1.4043 1.2101 Weighted Average cost of capital (WACO) 912% 7.66% Marginal cost of capital (MACC) 10.65% 7.58% ncing will be preferred under the criteria of EPS, whereas teria of MPS, Alternative I of Alternative II of financing will be preferred under the © Financial leverage, WACC and marginal cost of capital. PROBLEM 17 Axar Ltd. has a Sales of € 68,00,000 with a Variable cost Ratio of 60%. The company has fixed cost of €16,32,000. The capital of the company comprises of 12% long term debt, %1,00,000 Preference Shares of € 10 each carrying dividend rate of 10% and 1,50,000 equity shares. The tax rate applicable for the company is 30%. At current sales level, DETERMINE the Interest, EPS and amount of debt for the firm if a 25% decline in Sales will wipe out all the EPS. Solution: Break Even Sales = % 6800000 x 0.75 = 51,00,000 Income Statement (Amount in @) Original [Calculation of Interest at BEP | Now at present (backward calculation) level Sales (68,00,000 51,00,000 68,00,000 Less: Variable Cost 40,80,000 30,60,000 40,80,000 Contribution 27,20,000 20,40,000 27,20,000 Less: Fixed Cost 16,32,000 16,32,000 16,32,000, EBIT 10,88,000 4,08,000 10,88,000 Less: Interest (EBIT-PBT) 2 3,93,714 3,93,714 PBT 2 14,286(10,000/70%) 694,286 Less: Tax @ 30% (or PBT-PAT) 2 4286 2,08,286www.myeduneeds.com PAT ? 10,000(Nil + 10,000) 486,000 ‘Less: Preference Dividend 10,000 10,000 10,000 Earnings for Equity share holders ? Nil (at BEP) 4,76,000 ‘Number of Equity Shares 1,50,000. 1,50,000 1,50,000 S 2 = 1733 So Interest =€ 3,93,714, E S = 3.1733, Amount of debt = 3,93,714/12% = 32,80,950 PROBLEM 18 Company X and Company Y are in the same risk class, and are identical in ¢ Company X uses debt while Company Y does not. The levered firm has 9,00,000 debentur shion except that carrying 10% rate of interest. Both the firms earn 20% before interest and taxes on their total assets of & 15 lakh. Assume perfect capital markets, rational investors and so on; a tax rate of 50% and capitalisation rate of 15% for an all equity company. (i) Compute the value of firms X and Y using the Net Income (NI) approach, (ii) Compute the value of each firm using the Net Operating Income (NOI) approach. (ii) Using the NOT approach, caleulate the overall cost of capital (ko) for firms X and Y. (iv) Which of these two firms has an optimal capital structure according to the NOT approach? Why? Solution: () Computation of Value of Firms X and Y using NI Approach: NI approach assumes no taxes. Since, the tax rate is given in the problem, we have to work out of NI approach, Value of Firm = MV of Eq LV of Debt X® Y@® EBIT (15 lakhs x 20%) 3,00,000 3,00,000 Less: Interest 90,000 - PBT 2,10,000, Less: Tax @ 50% 1,05,000 | _1,50,000 PAT (Earnings for equity holders 1,05,000. 1,50,000. Ke 15% 15% Capitalized value of equity 7,00,000 10,00,000 Market Value of Debt 9,00,000 - Market Value of Firm 16,00,000 10,00,000 (i) Computation of value of firms X and Y using NOT approach: Net Operating Income approach assumes no taxes. Since the tax rate is given in the problem, we have to work out using MM approach, which is an extension of NOI approach. Value of unlevered firm (Y) ere =&3,00,000 (1 - 0.5)/ 0.15 =% 10,00,000 Value of Levered Firm (X) = Value of Unlevered Firm + Debt (Tax rate) = Value of Y Ltd. + Debt (Tax rate) =%10,00,000 + %9,00,000 x 50%) =% 14,50,000 (iii) Computation of Overall Cost of Capital (ko) using NOI approach: For Y Ltd —www.myeduneeds.com ko =ke = 15% (as there is no debt) For Firm X— Value of firm @) 14,50,000 Less: Value of debt @) 9,00,000 Market value of equity @ 5,50,000 Equity Earnings ke Warket Value of Equity * 100 __Rs:1.05,000 — 19% Fee eoeg x 100 = 19% ki =0.10.x (1.0- 0.50) = 5% ko = (19x BEESB2) «(5 x BBL) — 0.310 is.450,000, its.14.50,000, (iv) Out of two firms, Firm X seems to have optimum capital structure as it has lower cost of capital higher value of firm.