Numericals on Capital Structure Theories
1. A company’s annual net operating profit (EBIT) is Rs.50000. The company has Rs.200000, 10%
debentures. The equity capitalization rate (ke) of the company is 12.5 per cent. With no taxes, (i) find out
the value of the firm according to Net Income Approach, (ii) find out the value of the firm in case the
amount of debentures increase by Rs. 100000 and (iii) find out the value of the firm in case the amount
of debentures decrease by Rs. 100000.
2. Using the information given in question 1 and that overall capitalization rate (overall cost of capital) is
12.5 per cent. (i) Find out the value of the firm and equity capitalization rate according to Net Operating
Income Approach, (ii) find out the value of the firm in case the amount of debentures increase by Rs.
100000 and (iii) find out the value of the firm in case the amount of debentures decrease by Rs.
100000.
3. In case a firm has 20 per cent debt and 80 per cent equity in its capital structure, and the cost of debt is
10 per cent and cost of equity is 15 per cent, what is the overall cost of capital according to the
Traditional approach? What is the overall cost of capital when debt increases to 50 per cent and the
cost of debt increases to 11 per cent and cost of equity to 16 per cent? Further, what is the overall cost
of capital when debt increases to 70 per cent and the cost of debt increases to 14 per cent and cost of
equity to 20 per cent?
4. Assume a firm has EBIT of Rs.40000. The firm has 10 per cent debentures of Rs.100000 and its current
equity capitalization rate is 16 per cent. The current value of the firm and its overall cost of capital is? In
case the firm is considering increase in debentures by Rs.50000 and using proceeds to retire equity, cost
of debt would increase to 11 per cent and cost of equity to 17 per cent? In case the firm is considering
increase in debentures by Rs.100000 instead of Rs.50000 and using proceeds to retire equity, cost of
debt would increase to 12.5 per cent and cost of equity to 20 per cent?
5. Assuming no taxes and given the earnings before interest and taxes (EBIT), interest (I) at 10% and equity
capitalisation rate (ke) below, calculate the total market value of each firm:
Firms EBIT I ke (%)
X Rs.200000 Rs.20000 12
Y 300000 60000 16
Z 500000 200000 15
W 600000 240000 18
Also determine the weighted average cost of capital.
6. Company X and Company Y are in the same risk class and are similar in every respect except that Firm X
uses debt while firm Y does not. The levered firm has Rs.900000 debentures carrying 10 per cent
interest. Both firms earn 20 per cent operating profit on their total assets of Rs.15 lakhs. Assume perfect
capital markets, rational investors so on; a tax rate of 35 per cent and capitalization rate of 15 per cent
for an all equity firm.
(i) Compute the value of the firms X and Y using Net Income Approach.
(ii) Compute the value of each firm using the Net Operating Income Approach.
(iii) Using NOI approach, calculate the overall cost of capital (ko) for firms X & Y.
(iv) Which of these two firms has an optimal capital structure according to the NOI approach? Why?
7. A company wishes to determine the optimal capital structure. From the following selected information
supplied to you, determine the optimal capital structure of the company.
Situation Debt (Rs.) Equity (Rs.) After-tax cost Ke (%)
of debt (%)
1 400000 100000 9 10
2 250000 250000 6 11
3 100000 400000 5 14
8. A company’s current operating income is Rs.4 lakhs. The company has Rs.10 lakhs 10% debt outstanding.
Its cost of equity is estimated to be 15 per cent.
(i) Determine the current value of the firm using the Traditional Valuation approach.
(ii) Calculate the overall capitalization rate and both types of leverage ratios: B/S and B/V.
(iii) The firm is considering increasing its leverage by raising additional Rs.500000 debt suing
proceeds to retire that amount of equity. As a result of increased financial risk, cost of debt is
likely to increase to 12 per cent and cost of equity to 18 per cent. Would you recommend the
plan?
