CA Sunil Keswani FM-SM Pre-Exam Revision

COST OF CAPITAL - CONCEPTS

1. Cost of Capital
It is the weighted average of cost of various sources from which capital is raised.
It is the minimum return to be earned by the company to meet the expectations of the capital
providers.

Cost of Capital
(Ko)

Cost of
Cost of Debt Cost of PSC Cost of Equity
Retained
(Kd) (Kp) (Ke)
Earnings (Kr)

2. General Points
I = Interest rate
T = Tax Rate
RV = Redeemable value
N = No. of years to maturity
PD = Preference dividend
NP = P0 = Net Proceeds /Issue Price/ Market Value/ Face value
Flotation cost to be considered on issue price if question is silent.
Redeemable value to be taken at par value if question is silent.
 CA Sunil Keswani FM-SM Pre-Exam Revision
2. Cost of Irredeemable Debt
!(#$%)
Kd = × 100
'(

4. Cost of Redeemable Debt – Approximation Method

!"#$%
!(#$%))* +
&
Kd = $%'!" × 100
* ( +

5. Cost of Redeemable Debt – YTM Method

Option - 1
Find Kd using approximation method say x.y%
Find NPV at x% and (x + 1)%
NPV = PVCI – PVCO
= [Int.(1 – t) ´ PVAF(r,n)] + [RV ´ PVF(r,n)] – Cost today
,-./0 02%/ '(3
Kd = IRR = Lower rate + (,-./0 02%/ '(3$4567/0 82%/ '(3) × (%&'ℎ *+,- − /01 *+,-)

Option - 2
Find NPV at rates given in ques2on.
NPV = PVCI – PVCO = [Int.(1 – t) ´ PVAF(r,n)] + [RV ´ PVF(r,n)] – Cost today
We require one +ve NPV and one -ve NPV.
,-./0 02%/ '(3
Kd = IRR = Lower rate + (,-./0 02%/ '(3$4567/0 82%/ '(3) × (%&'ℎ *+,- − /01 *+,-)

6. Cost of Redeemable Debt in instalment

Calculate cash flows of each year
Cash flow = [Interest ´ (1 – t)] + Amortized maturity amount p.a.
,-./0 02%/ '(3
Kd = IRR = Lower rate + (,-./0 02%/ '(3$4567/0 82%/ '(3) × (%&'ℎ *+,- − /01 *+,-)
 CA Sunil Keswani FM-SM Pre-Exam Revision
7. YTM vs Intrinsic Value

If we find rate for

a given issue YTM
price
Rate
If we find issue
price for a given Intrinsic Value
rate

Intrinsic Value (IV) = Present value of all future cash inflows

IV of bond/debenture = PV of interest + PV of redemption value

8. Decision on basis of Intrinsic value (IV)

(A) If IV > Current price = Recommend to buy or Under-priced
(B) If IV < Current price = Not recommend to buy or Over-priced

9. Convertible Debentures
Redeemable value = Higher of either cash or equity value
Value of one equity share = P0 ´ (1 + g)n

10. Cost of Irredeemable Preference Shares

(9
Kp = '( × 100
 CA Sunil Keswani FM-SM Pre-Exam Revision
11. Cost of Redeemable Preference Shares – Approximation Method
!"#$%
(9)* +
&
Kp = $%'!" × 100
* ( +

12. Cost of Redeemable Preference Shares – YTM Method

,-./0 02%/ '(3
Kp = IRR = Lower rate + (,-./0 02%/ '(3$4567/0 82%/ '(3) × (%&'ℎ *+,- − /01 *+,-)

13. Income Statement

Particulars Amount

Sales ---

Less: Variable Cost ---

Contribution ---

Less: Fixed Cost ---

Earnings Before Interest & Tax (EBIT) ---

Less: Interest ---

Earnings Before Tax (EBT) ---

Less: Tax ---

Earnings After Tax (EAT) ---

Less: Preference Dividend ---

Earnings Available for Equity ---

Number of Equity Shares ---

Earnings per Share ---

 CA Sunil Keswani FM-SM Pre-Exam Revision

14. Cost of Equity – Dividend Approach

9
Ke = × 100
(:

15. Cost of Equity – Earning Approach

;
Ke = × 100
(:

16. Cost of Equity – Dividend Growth Approach or Constant Growth Approach or

Gordon Model
9#
Ke = (: + '

17. Cost of Equity – Earning Growth Approach

;#
Ke = (: + '

18. Cost of Equity – Capital Assets Pricing Model

Ke = Rf + (Rm – Rf)(β)

19. Cost of Equity – Realized Yield Approach

<5=5</><)?2@5%2A B25>
Return of one year =
!>=/C%D/>%
&
Ke = 4(1 + 51) × (1 + 52) × (1 + 53) … … … . (1 + 5:) − 1

Or If year wise price data is not given than use YTM method

Where
D = Dividend per share = E ´ DP Ratio
E = Earning per share
D1 = Expected dividend per share = D0(1 + g) = E1 ´ DP Ratio
 CA Sunil Keswani FM-SM Pre-Exam Revision
E1 = Expected earning per share = E0(1 + g)
9(E
DP Ratio = Dividend payout ratio = ;(E × 100

P0 = Net Proceeds / Market value / Face value

G = Growth rate
Option – 1 – g = (b)(r)
& 9>
Option – 2 – g = ; 9: − 1

Rf = Risk Free Return

Rm = Market rate of return
Rm – Rf = Market risk premium
Β = Beta coefficient

20. Cost of Retained Earnings

Kr = Ke; If there is no flotation cost i.e. NP can’t be computed

Kr = Ke; If there is flotation cost i.e. NP can be computed

In case if personal tax is given than

Kr = Ke(1 – tp)(1 – B)
tp = Personal tax rate
B = Brokerage on income

21. Weighted Average Cost of Capital (WACC = Ko)

- It is the weighted average of cost of all sources taken together.
- Ko = (Ke)(We) + (Kr)(Wr) + (Kp)(Wp) + (Ke)(Wd)
- Weights can be either book value, market value or target value.
- Prefer to use MV weights if question is silent, provided MV of all sources can be
computed.
 CA Sunil Keswani FM-SM Pre-Exam Revision

22. Points to Remember (PTRs)

- Flotation cost are not to be considered for calculating market value weights.
- Term loan doesn’t have any market value. If market value is required than consider its
book value to be its market value.
- We always require ex-dividend or ex-interest values.
- Ex-dividend value = Cum-dividend value – Dividend amount
- Ex-interest value = Cum-interest value – Interest amount
- Market value of an equity share represents value towards face value and reserve &
surplus.
- If Kr ≠ Ke then distribute the total market value between face value and reserve and
surplus in the ratio of their book value.

22. Weighted Marginal Cost of Capital

It is the cost of raising additional rupee of capital.
- Ko = (Ke)(We) + (Kr)(Wr) + (Kp)(Wp) + (Ke)(Wd)
 CA Sunil Keswani FM-SM Pre-Exam Revision

COST OF CAPITAL - QUESTIONS

Question – 1
A company issues:
• 15% convertible debentures of `100 each at par with a maturity period of 6 years. On maturity,
each debenture will be converted into 2 equity shares of the company. The risk-free rate of return
is 10%, market risk premium is 18% and beta of the company is 1.25. The company has paid
dividend of `12.76 per share. Five years ago, it paid dividend of `10 per share. Flotation cost is
5% of issue amount.
• 5% preference shares of `100 each at premium of 10%. These shares are redeemable after 10
years at par. Flotation cost is 6% of issue amount.
Assuming corporate tax rate is 40%.
(i) Calculate the cost of convertible debentures using the approximation method.
(ii) Use YTM method to calculate the cost of preference shares.

Year 1 2 3 4 5 6 7 8 9 10
PVIF0.03,t 0.971 0.943 0.915 0.888 0.863 0.837 0.813 0.789 0.766 0.744
PVIF0.05,t 0.952 0.907 0.864 0.823 0.784 0.746 0.711 0.677 0.645 0.614
PVIFA0.03,t 0.971 1.913 2.829 3.717 4.580 5.417 6.230 7.020 7.786 8.530
PVIFA0.05,t 0.952 1.859 2.723 3.546 4.329 5.076 5.786 6.463 7.108 7.722

Interest rate 1% 2% 3% 4% 5% 6% 7% 8% 9%
FVIFi,5 1.051 1.104 1.159 1.217 1.276 1.338 1.403 1.469 1.539
FVIFi,6 1.062 1.126 1.194 1.265 1.340 1.419 1.501 1.587 1.677
FVIFi,7 1.072 1.149 1.230 1.316 1.407 1.504 1.606 1.714 1.828

Solution
(i) As per CAPM, Ke = Rf + [β × (Rm – Rf)] = 10 + (18 ´ 1.25) = 32.5%
Also, let growth rate = g
Now, 10(1 + g)5 = 12.76
(1 + g)5 = 1.276
From the Interest rate table, we can say that g = 5% as for five years at 5% value is 1.276.
!"
As per Constant growth model, Ke = #$ + "
"%.'(("*+.+,)
0.325 = #+
+ 0.05
".../0
0.275 = #+
P0 = 48.72
Thus, share price today = `48.72
Redemption value will be higher of:
(a) Cash value of debenture = `100
(b) Value of equity shares = 2 ´ 48.72 ´ (1 + 0.05)6 = 2 ´ 48.72 ´ 1.340 = `130.57
 CA Sunil Keswani FM-SM Pre-Exam Revision
Thus, redemption value will be `130.57
As per approximation method,
1("23)*[(5627#)÷9]
Kd = [(7#*56)÷%]
I = 15% ´ 100 = 15 t = 0.40 RV = 130.57 NP = 100 – 5% = 95
", ("2+.<+)*[{".+.,'2/,}÷(] "<./.
Kd = [{/,*".+..'}÷%]
= ""%.'0, = 0.1324 = 13.24%

(ii) Cost of Preference Shares using YTM Method:

Preference dividend = 5% ´ 100 = 5
Redemption value = 100 years to maturity = 10
Investment = 100 + (100 ´ 10%) – (110 ´ 6%) = `103.40
NPV at 5% = PVCI – PVCO
= PV of Preference dividend + PV of Redemption Value – Investment
= [5 × 7.722] + [100 × 0.614] – 103.40 = - `3.39
NPV at 3% = PVCI – PVCO
= PV of Preference dividend + PV of Redemption Value – Investment
= [5 × 8.530] + [100 × 0.744] – 103.40 = `13.65
7#6! "..(,
Cost of Preference (Kp) = L + &7#6 ' () − +) = 3 + &"..(,2(2.../)' (5 − 3) = 4.60%
! 27#6"
 CA Sunil Keswani FM-SM Pre-Exam Revision

Question – 2
SK Ltd. issued 12% Bonds of face value `2,000 each, which are redeemable after 5 years. Tax rate is
30% and the bonds are amortized equally over the life of bonds. Compute the value of the bond if the
investor expects a minimum return of 8% from the bonds.

Solution
Year Principal Principal Interest Payment Net of Total Cash
Outstanding Repayment Tax Flows
1 2,000 400 2,000×12%×70% = 168 568
2 1,600 400 1,600×12%×70% = 534.40
134.4
3 1,200 400 1,200×12%×70% = 500.80
100.80
4 800 400 800×12%×70% = 67.20 467.20
5 400 400 400×12%×70% = 33.60 433.60
Value of the bond
= [568×PVF(8%,1)] + [534.40×PVF(8%,2)] + [500.80×PVF(8%,3)] + [467.20×PVF(8%,4)] +
[433.60×PVF(8%,5)]
= (568×0.926) + (533.40×0.857) + (500.80×0.816) + (467.20×0.763) + (433.60×0.713)
=`2,057.38
 CA Sunil Keswani FM-SM Pre-Exam Revision

Question – 3
JC Ltd. is planning an equity issue in current year. It has an earning per share (EPS) of `20 and
proposes to pay 60% dividend at the current year end. With a PE ratio 6.25, it wants to offer the issue
at market price. The flotation cost is expected to be 4% of the issue price.
Required: Determine the required rate of return for equity share (cost of equity) before the issue and
after the issue.

Solution
Current market price (P0) = EPS × PE Ratio = 20 × 6.25 = `125
Rate of return (r) = 1 ÷ PE Ratio = 1 ÷ 6.25 = 16%
Retention ratio (b) = 100 – Dividend payout ratio = 100 – 60% = 40% = 0.40
Growth rate = b × r = 0.40 × 0.16 = 0.064
D0 = EPS × Dividend payout ratio = 20 × 60% = `12
D1 = D0 × (1 + g) = 12 × (1+0.064) = `12.768
Proceeds from new issue of shares = 125 – (125 × 4%) = `120

!" "%.'(0
Cost of equity before issue (ke) = #+ + " = "%,
+ 0.064 = 0.1661 = 16.61%

!" "%.'(0
Cost of equity after issue (ke) = #+ + " = "%+
+ 0.064 = 0.1704 = 17.04%
 CA Sunil Keswani FM-SM Pre-Exam Revision
Question – 4
Determine the cost of capital of SK ltd. using the book value and market value weights from the
following information:
Sources Book Value (`) Market Value (`)
Equity shares 1,20,00,000 2,00,00,000
Retained earnings 30,00,000 -
Preference shares 36,00,0000 33,75,000
Debentures 9,00,000 10,40,000
Additional information:
(a) Equity: Equity shares are quoted at `130 per share and a new issue priced at `125 per share will
be fully subscribed; flotation cost will be `5 per share.
(b) Dividend: During the previous 5 years, dividends have steadily increased from `10.60 to `14.19
per share. Dividend at the end of the current year is expected to be `15 per share.
(c) Preference shares: 15% Preference shares with face value of `100 would realise `105 per share.
(d) Debentures: The company proposes to issue 11-year 15% debentures but the yield on debentures
of similar maturity and risk class is 16%; flotation cost is 2%.
(e) Tax: Corporate tax rate is 35%. Ignore dividend tax.
(f) Flotation cost would be calculated on face value.

Solution
(i) Calculation of g :
₹10.6(1 + "), = ₹14.19
"<."/
Or, (1 + "), = "+.(
= 1.338
Table (FVIF) suggests that ₹ 1 compounds to ₹ 1.338 in 5 years at the compound rate of 6
percent. Therefore, " is 6 per cent.
!# ₹",
Cost of Equity (7? ) = # + " = ₹"%,2₹, + 0.06∗ = 0.125 + 0.06 = 0.185
$ 2@
!# ₹",
(ii) Cost of Retained Earnings (7C ) = #$
+ " = ₹"%, + 0.06 = 0.18
#! ₹",
(iii) Cost of Preference Shares 97D : = #$
= ₹"+, = 0.1429
%&'() ₹#$$'₹.#.01⋆
1("23)*F G ₹",("2+..,)*H I
## years
(iv) Cost of Debentures (7E ) = %&+()
*
= ₹#$$+₹.#.01 ⋆ = 0.1095
, ,
*Since yield on similar type of debentures is 16 per cent, the company would be required to
offer debentures at discount.
Market price of debentures (approximation method) =₹ 15 ÷ 0.16 = ₹93.75
Sale proceeds from debentures = ₹93.75 − ₹2 (i.e., floatation cost) = ₹91.75
OR Market value (P+ ) of debentures can also be found out using the present value method:
>+ = Annual Interest × PVIFA (16%, 11) + Redemption value × PVIF (16%, 11)
>+ = ₹15 × 5.029 + ₹100 × 0.195 = `94.935
Net Proceeds = ₹94.935 − 2% of ₹100 = ₹92.935
Accordingly, the cost of debt can be calculated
Total Cost of capital [BV weights and MV weights] (Amount in (₹) lakh)
 CA Sunil Keswani FM-SM Pre-Exam Revision
Source of Capital Weights Specific Total Cost
BV MV cost (K) (BV ´ K) (MV ´ K)
Equity shares 120 160* 0.1850 22.2 29.6
Retained Earnings 30 40* 0.1800 5.4 7.2
Preference Shares 36 33.75 0.1429 5.14 4.82
Debentures 9 10.4 0.1095 0.986 1.139
195 244.15 33.73 42.76
*Market Value of equity has been apportioned in the ratio of Book Value of equity and retained
earnings i.e., 120: 30 or 4: 1.
Weighted Average Cost of Capital (WACC):
₹...'.
Using Book Value = ₹"/,
= 0.1729 or 17.29%
₹<%.'(
Using Market Value = ₹%<<.", = 0.1751 or 17.51%
 CA Sunil Keswani FM-SM Pre-Exam Revision
Question – 5
The latest Balance Sheet of SK Ltd. is given below: (`‘000)
Ordinary shares (50,000 shares) 500
Share Premium 100
Retained profits _600
1,200
8% Preference shares 400
13% Perpetual debts (Face value `100 each) _600
2,200
The ordinary shares are currently priced at `39 ex-dividend each and `25 preference share is priced
at `18 cum-dividend. The debentures are selling at 110% ex-interest and tax is paid by SK Ltd. at
40%. SK Ltd. has a beta of 0.90, risk free return is 10% & market return is 20%. Calculate the weighted
average cost of capital, (based on market value) WACC of SK Ltd.

Solution
Cost of equity (Ke) = Rf + (Rm – Rf)(β) = 10 + (20 – 10)(0.90) = 19%
Since there is no flotation cost, thus cost of retained earning (Kr) = Ke = 19%
Price of preference share ex-dividend = 18 – (25 × 8%) = 18 – 2 = `16
#C?J. !KLKE?9E %,×0%
Cost of preference shares (Kp) = #+
= "(
= 12.5%
Market price of debenture = 100 × 110% = `110
1("23) "++×".%
Cost of debt (Kd) = #+
= ""+
× 100 = 7.09%
Calculation of weighted average cost of capital
Source Market Value (`) (A) Cost (B) A×B
Equity shareholder fund 50,000×39 = 19,50,000 19% 3,70,500
Preference Share <,++,+++ 12.50% 32,000
%,
× 16 = 2,56,000
Debentures (,++,+++ 7.09% 46,794
"++
× 110 = 6,60,000
28,66,000 4,49,294
<,</,%/<
Weighted average cost of capital = %0,(+,+++ × 100 = 15.68%
 CA Sunil Keswani FM-SM Pre-Exam Revision
Question – 6
Following are the information of TT Ltd.:
Particulars
Earnings per share `10
Dividend per share `6
Expected growth rate in Dividend 6%
Current market price per share `120
Tax rate 30%
Requirement of Additional Finance `30 lakhs
Debt Equity Ratio (For additional finance) 2:1
Cost of Debt
0 - 5,00,000 10%
5,00,001 – 10,00,000 9%
Above 10,00,000 8%
Assuming that there is no Reserve and Surplus available in TT Ltd. You are required to:
(a) Find the pattern of finance for additional requirement
(b) Calculate post tax average cost of additional debt
(c) Calculate cost of equity
(d) Calculate the overall weighted average after tax cost of additional finance

Solution
(a) Pattern of raising capital
Debt (30,00,000 × 2/3) = `20,00,000
Equity (30,00,000 × 1/3) = `10,00,000
Equity Fund:
Equity (additional) = `10,00,000
`10,00,000
Debt Fund:
10% Debt = `5,00,000
9% Debt = `5,00,000
8% Debt = `10,00,000
`20,00,000

193?C?P3 ("23) [(,,++,+++×"+%)*(,,++,+++×/%)*("+,++,+++×0%)]("2+..+)

(b) Kd = #+
× 100 = %+,++,+++
× 100
",%%,,++
= %+,++,+++ × 100 = 6.125%

!("*Q) (×("*+.+() ,..(

(c) Ke = #+
+"= "%+
+ 0.06 = "%+
+ 0.06 = 0.113 = 11.3%
 CA Sunil Keswani FM-SM Pre-Exam Revision
(d) Weighted average cost of capital
Source Amount (`) Weight Cost of capital after tax WACC
Equity Fund 10,00,000 1/3 11.3 3.767
Debt Fund 20,00,000 2/3 6.125 4.083
Total 30,00,000 1 7.85
 CA Sunil Keswani FM-SM Pre-Exam Revision
Question – 7
The SK Company has following capital structure at 31st March, 2021 which is considered to be
optimum:
13% debenture `3,60,000
11% Preference share capital `1,20,000
Equity share capital (2,00,000 shares) `19,20,000
The company’s share has a current market price of `27.75 per share. The expected dividend per share
in next year is 50% of the 2021 EPS. The EPS of last 10 years is as follows. The past trends are
expected to continue:
Year 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021
EPS 1.000 1.120 1.254 1.405 1.574 1.762 1.974 2.211 2.476 2.773
The company can issue 14% new debenture. The company’s debenture is currently selling at `98. The
new preference issue can be sold at a net price of `9.80, paying a dividend of `1.20 per share. The
company’s marginal tax rate is 50%.
(a) Calculate the after tax cost (i) of a new debts and new preference share capital, (ii) of ordinary
equity assuming new equity comes from the retained earnings.
(b) Calculate the marginal cost of capital
(c) How much can be spent for capital investment before new ordinary share must be sold? Assuming
that retained earnings available for next year’s investment are 50% of 2021 earnings.
(d) What will be marginal cost of capital {cost of fund raised in excess of the amount calculated in
part (c)} if the company can sell new ordinary shares to net `20 per share? The cost of debt and
of preference capital is constant.

Solution
Existing Capital Structure Analysis
Source of Capital Amount Ratio
Equity 19,20,000 0.80
Preference Shares 1,20,000 0.05
Debentures 3,60,000 0.15
24,00,000 1

1("23) ("<%×"++)("2+.,+)
(a) (i) Cost of new debt = Kd = #+
= /0
= 0.07143 = 7.143%
#! ".%+
Cost of new preference shares = Kp = #+
= /.0+ = 0.12245 = 12.245%
!" %.''.×,+%
(ii) Cost of retained earnings = Kr = #+ + " = %'.',
+ 0.12 = 0.17 = 17%
%.''.
Here g = %.<'( − 1 = 0.12 = 12%
 CA Sunil Keswani FM-SM Pre-Exam Revision

(b) Marginal Cost of Capital

Source of Capital Weight Cost WMCC
Equity 0.80 0.17 0.1360
Preference Shares 0.05 0.12245 0.0061
Debentures 0.15 0.07143 0.0107
1.00 0.1528 or
15.28%

(c) Amount of retained earnings available = 2.773 × 50% × 2,00,000 = `2,77,300

The ratio of equity in the total capital is 80%.
%,'',.++
Therefore, investment that can be done before issuing new equity shares = 0+%
= `3,46,625

!" %.''.×,+%
(d) Cost of new issue of equity shares = #+ + " = %+
+ 0.12 = 0.1893 = 18.93%
Marginal Cost of Capital
Source of Capital Weight Cost WMCC
Equity 0.80 0.1893 0.1514
Preference Shares 0.05 0.12245 0.0061
Debentures 0.15 0.07143 0.0107
1.00 0.1682 or
16.82%
 CA Sunil Keswani FM-SM Pre-Exam Revision

LEVERAGE - CONCEPTS
1. Income Statement
Particulars Amount
Sales ---
Less: Variable Cost ---
Contribution ---
Less: Fixed Cost ---
Earnings Before Interest & Tax (EBIT) ---
Less: Interest ---
Earnings Before Tax (EBT) ---
Less: Tax ---
Earnings After Tax (EAT) ---
Less: Preference Dividend ---
Earnings Available for Equity ---
Number of Equity Shares ---
Earnings per Share ---

!"#$%&'($&"#
2. PV Ratio = × "## = 100 – Variable Cost Ratio
)*+,-
.*%&*'+, !"-$
VC Ratio = × "##
)*+,-

3. PBT ´ (1 – t) = PAT
012
PBT = (45$)

4. Double means increase by 100%

Triple means increase by 200%
Becomes zero means decrease by 100%
 CA Sunil Keswani FM-SM Pre-Exam Revision
5. Risks in the business
Risk in business

Operating or Business Measured by Degree of

Due to Fixed cost
Risk Operating Leverage
Total or Overall pr
Due to Fixed financial Measured by Degree of Combined risk
Financial Risk
cost Financial Leverage

Due to Fixed cost,

Interest and Preference
Dividend

Measured by Degree of
Combined Leverage

6. Degree of Operating Leverage (DOL)

% 89:;<= >; ?@AB
DOL = % 89:;<= >; C:D=E

8F;GH>IJG>F;
DOL =
?@AB

7. Degree of Financial Leverage (DFL)

% 89:;<= >; ?KC
DFL = % 89:;<= >; ?@AB
?@AB
DFL (without preference shares) =
?@B
?@AB
DFL (with preference shares) = !"
?@B5L#$%M

8. Degree of Combined Leverage (DCL)

% 89:;<= >; ?KC
DCL = % 89:;<= >; C:D=E

8F;GH>IJG>F;
DCL (without preference shares) =
?@B
8F;GH>IJG>F;
DCL (with preference shares) = !"
?@B5L#$%M

DCL = DOL ´ DFL

 CA Sunil Keswani FM-SM Pre-Exam Revision

9. Higher the level of leverage, high will be the level of that particular risk and vice-
versa.

10. Operating BEP

Sales at which operating profit (EBIT) is zero
N>O=P 8FEG
Operating BEP (units) = 8F;GH>IJG>F; Q=H J;>G

N>O=P RFEG
Operating BEP (in `) = KS T:G>F
= Operating BEP units ´ Selling price per unit
U
Margin of Safety = VWX

DOL Fixed Cost Operating BEP MOS

High High High Low
Low Low Low High

11. DOL Analysis

Situation Result or Interpretation

No Fixed Cost • DOL = 1

• No operating risk

High Fixed Cost • High BEP

• High DOL

Low Fixed Cost • Low BEP

• Low DOL

Sales > Operating BEP • Existing Profit

• DOL is positive

Sales < Operating BEP • Existing Loss

• DOL is negative
 CA Sunil Keswani FM-SM Pre-Exam Revision
12. Financial BEP
Level of EBIT at which EPS is zero
KV
Financial BEP = Interest + (U5G)

(?@AB5A;G=H=EG)(U5G) 5 KH=Y=;R= P>Z>P=;P

EPS = [F. FY =]J>G^ E9:H=E

13. Analysis of DFL

Situation Result or Interpretation

No Fixed Finance Cost • DFL = 1

• No financial risk

High Fixed Financial Cost • High Financial BEP

• High DFL

Low Fixed Financial Cost • Low Financial BEP

• Low DFL

EBIT > Financial BEP • EPS is positive

• DFL is positive

EBIT < Financial BEP • EPS is negative

• DFL is negative

14. Overall BEP

It is the level of sales at which EPS is zero.
!"
N>O=P RFEG_A;G=H=EG_ L M
#$%
Overall BEP in units =
8F;GH>IJG>F; Q=H J;>G

!"
N>O=P RFEG_A;G=H=EG_ L#$%M
Overall BEP in ` = = Overall BEP units ´ Selling price per unit
KS T:G>F
 CA Sunil Keswani FM-SM Pre-Exam Revision
15. Trading on Equity
If Rate of Interest < Return on Investment (ROI)
If Rate of Interest > Return on Investment (ROI)

16. Analysis of DCL

DOL DFL Result or Interpretation

High High • High risky situation

Low Low • Low risk situation

High Low • Moderate risk

• EBIT is low
• No benefit of trading on equity

Low High • Moderate risk

• EBIT is high
• Benefit of trading on equity available
 CA Sunil Keswani FM-SM Pre-Exam Revision

LEVERAGE QUESTIONS
Question – 1
Details of a company for the year ended 31st March, 2022 are given below:
Sales `86 lakhs
Profit Volume (P/V) Ratio 35%
Fixed cost excluding interest expenses `10 lakhs
10% Debt `55 lakhs
Equity Share Capital of `10 each `75 lakhs
Income Tax rate 40%
Required:
(i) Determine company’s return on capital employed (pre-tax) and Eps.
(ii) Does the company have a favourable financial leverage?
(iii) Calculate operating and combine leverages of the company
(iv) Calculate percentage change in EBIT, if sales increases by 10%.
(v) At what level of sales, the Earning before Tax (EBT) of the company will be equal to zero?

Solution
Income Statement
Particulars Amount (`)
Sales 86,00,000
Less: Variable cost (86,00,000 ´ 65%) 55,90,000
Contribution 30,10,000
Less: Fixed cost 10,00,000
EBIT 20,10,000
Less: Interest (10% ´ 55,00,000) 5,50,000
EBT 14,60,000
Less: Tax @ 40% 5,84,000
EAT/EAE 8,76,000

!"#$ 12,42,222
(i) Return on capital employed = %&'()&* ,-'*./,0 × 100 = 4,52,22,222 × 100 = 15.46%
!6! @,AB,222
Earning per share = 7.. .9 !:;()/ <=&>,?
= A,C2,222 = `1.168
(ii) Since, the return on capital employed (15.46%) is more than the interest rate (10%), thus the
company has a favourable financial leverage.
%.D)>(E;)(.D 52,42,222
(iii) Operating leverage = !"#$
= 12,42,222 = 1.498 times
%.D)>(E;)(.D 52,42,222
Combined leverage = !"$
=
4F,B2,222
= 2.062 times
% %=&DH, (D !"#$
(iv) Operating leverage = % %=&DH, (D <&*,?
% %=&DH, (D !"#$
1.498 = I42
% Change in EBIT = +14.98
 CA Sunil Keswani FM-SM Pre-Exam Revision
Thus, EBIT increases by 14.98%
(v) EBT = Contribution – Fixed cost – Interest
0 = (Sales ´ 35%) – 10,00,000 – 5,50,000
Sales = 15,50,000 ÷ 35% = `44,28,571
 CA Sunil Keswani FM-SM Pre-Exam Revision
Question – 2
The following data is available for Stone Ltd.:
(`)
Sales 5,00,000
(-) Variable cost @ 40% 2,00,000
Contribution 3,00,000
(-) Fixed cost 2,00,000
EBIT 1,00,000
(-) Interest _25,000
Profit before tax _75,000
Using the concept of leverage, find out
(i) The percentage change in taxable income if EBIT increases by 10%.
(ii) The percentage change in EBIT if sales increases by 10%.
(iii) The percentage change in taxable income if sales increases by 10%.
Also verify the results in each of the above case.

Solution
J.D)>(E;)(.D 5,22,222
Degree of operating leverage (DOL) = !"#$
=
4,22,222
=3
!"#$ 4,22,222
Degree of financial leverage (DFL) = !"$
= AC,222
= 1.33
J.D)>(E;)(.D 5,22,222
Degree of combined leverage (DCL) = !"$
= AC,222
=4
(i) Required % change in taxable income = DFL × Change in EBIT % = 1.33 × 10 = 13.33%

Verification
(`)
New EBIT (1,00,000 + 10%) 1,10,000
(-) Interest _25,000
Profit before tax _85,000
@C,222KAC,222
% change in taxable income = AC,222
× 100 = 13.33%

(ii) Required % change in EBIT = DOL × Change in Sales % = 3 × 10 = 30%

Verification
(`)
New Sales (5,00,000 + 10%) 5,50,000
(-) Variable cost @ 40% 2,20,000
Contribution 3,30,000
(-) Fixed cost 2,00,000
EBIT 1,30,000
4,52,222K4,22,222
% change in taxable income = × 100 = 30%
4,22,222

(iii) Required % change in taxable income = DCL × Change in Sales % = 4 × 10 = 40%

CA Sunil Keswani FM-SM Pre-Exam Revision

Verification
(`)
New Sales (5,00,000 + 10%) 5,50,000
(-) Variable cost @ 40% 2,20,000
Contribution 3,30,000
(-) Fixed cost 2,00,000
EBIT 1,30,000
(-) Interest _25,000
Profit before tax 1,05,000
4,2C,222KAC,222
% change in taxable income = AC,222
× 100 = 40%
 CA Sunil Keswani FM-SM Pre-Exam Revision
Question – 3
Calculate the operating leverage, financial leverage and combined leverage from the following data
under Situation I and II and Financial Plan A and B:
Installed Capacity 4,000 units
Actual Production and Sales 75% of capacity
Selling Price `30 per unit
Variable Cost `15 per unit
Fixed Cost:
Under Situation I `15,000
Under Situation II `20,000
Financial Plan
A (`) B (` )
Equity 10,000 15,000
Debt (Rate of interest at 20%) 10,000 5,000
20,000 20,000

Solution
Particulars Situation I Situation II
Contribution [4,000 × 75% × (30 – 15)] 45,000 45,000
Less: fixed cost (15,000) (20,000)
EBIT 30,000 25,000
Operating Leverage (Contribution/EBIT) 1.5 1.8

Calculation of Financial & Combined Leverage

Situation I Situation II
Financial Plan
A B A B
EBIT 30,000 30,000 25,000 25,000
Less: Interest on debt (2,000) (1,000) (2,000) (1,000)
EBT 28,000 29,000 23,000 24,000
Financial Leverage (EBIT/EBT) 1.07 1.03 1.09 1.04
 CA Sunil Keswani FM-SM Pre-Exam Revision
Question – 4
Following is the Balance Sheet of Gitashree Ltd. is given below:
Liabilities Amount (`)
Shareholder’s Fund
Equity Share Capital (`10 each) 1,80,000
Reserve & Surplus 60,000
Non-Current Liabilities (10% Debentures) 2,40,000
Current Liabilities 1,20,000
Total 6,00,000
Non-Current Assets 4,50,000
Current Assets 1,50,000
Total 6,00,000
The company’s total assets turnover ratio is 4. Its fixed operating cost is `2,00,000 and its variable
operating cost ratio is 60%. The income tax rate is 30%. Calculate:
(1) (a) Degree of operating leverage
(b) Degree of financial leverage
(c) Degree of combined leverage
(2) Find out EBIT if EPS is (a) `1; (b) `2; and (c) `0.

Solution
<&*,?
Total assets turnover ratio = $.)&* 6??,)?
<&*,?
4 = B,22,222
Sales = `24,00,000

Income Statement
Particulars Amount (`)
Sales 24,00,000
Less: Variable Cost@ 60% 14,40,000
Contribution 9,60,000
Less: Fixed Cost 2,00,000
EBIT 7,60,000
Less: Interest (2,40,000 × 10%) __24,000
EBT 7,36,000
Less: Income tax @ 30% 2,20,800
EAT/EAE 5,15,200

%.D)>(E;)(.D L,B2,222
(1) (a) Operating Leverage = !"#$
= A,B2,222 = 1.263 times

!"#$ A,B2,222
(b) Financial Leverage = !"$
= A,5B,222 = 1.033 times
 CA Sunil Keswani FM-SM Pre-Exam Revision
(c) Combined Leverage = OL × FL = 1.263 × 1.033 = 1.304 times

(!"#$K#D),>,?))(4K))
(2) (a) EPS = 7.. .9 ,:;()/ ?=&>,?
(!"#$K1F,222)(4K2.52)
1= 4@,222
EBIT = `49,714

(!"#$K#D),>,?))(4K))
(b) EPS = 7.. .9 ,:;()/ ?=&>,?
(!"#$K1F,222)(4K2.52)
2= 4@,222
EBIT = `75,429
(!"#$K#D),>,?))(4K))
(c) EPS = 7.. .9 ,:;()/ ?=&>,?
(!"#$K1F,222)(4K2.52)
0= 4@,222
EBIT = `24,000
 CA Sunil Keswani FM-SM Pre-Exam Revision
Question - 5
Following informa-on is given for X Ltd:
Total contribu-on (`) 4,25,000
Opera-ng leverage 3.125
15% Preference shares (`100 each) 1,000
Number of equity shares 2,500
Tax rate 50%
Calculate EPS of X Ltd., if 40% decrease in sales will result EPS to zero.

Solu%on
J.D)>(E;)(.D
Opera-ng leverage (DOL) =
!"#$
F,1C,222
3.125 = !"#$
EBIT = `1,36,000

% %=&HD, (D !O< 422

Combined leverage (DCL) = % %=&HD, (D <&*,? = F2
= 2.5
P%Q 1.C
Financial leverage = PRQ = 5.41C = 0.80

!"#$
Financial leverage = !"#$#"#%&# ()*)+#%+
!"$K
(-./)
4,5B,222
0.8 = -1,333
!"$K S T
-.3.13

EBT = `2,00,000

Statement of calcula%on of EPS

Par%culars Amount
EBT 2,00,000
(-) Tax @ 50% 1,00,000
EAT 1,00,000
(-) Preference dividend 15,000
Earning for equity 85,000
Number of equity shares 2,500
EPS 34
 CA Sunil Keswani FM-SM Pre-Exam Revision
Ques%on – 6
The following informa-on is available for SS Ltd.:
Profit volume (PV) ra-o - 30%
Opera-ng 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 Earnings Ra-o (PER) - 10
You are required to:
(a) Prepare the profit-loss statement of SS Ltd. and
(b) Find out the number of equity shares

Solu%on
U&), &9),> )&V C.B2%
Pre-tax interest rate = (4K))
= (4K2.52) = 8%
Interest = `1,25,000 ÷ 8% = `10,000
!"#$
Financial leverage = !"$
!"#$
1.5 = (!"#$K42,222)
(1.5)EBIT – 15,000 = EBIT
EBIT = `30,000

J.D)>(E;)(.D
Also, Opera-ng leverage = !"#$
%.D)>(E;)(.D
2= 52,222
Contribu-on = 60,000
Fixed cost = Contribu-on – EBIT = 60,000 – 30,000 = `30,000
J.D)>(E;)(.D B2,222
Sales = OW U&)(.
= 52%
= `2,00,000
Variable cost = Sales – Contribu-on = 2,00,000 – 60,000 = `1,40,000

(a) Statement of Profit or loss

Par%culars Amount
Sales 2,00,000
(-) Variable cost 1,40,000
Contribu-on 60,000
(-) Fixed cost 30,000
EBIT 30,000
(-) Interest 10,000
EBT 20,000
 CA Sunil Keswani FM-SM Pre-Exam Revision
(-) Tax @ 30% 6,000
EAT 14,000

XO< 4F2
(b) EPS = O! U&)(. = 42
= `14
!6$ 4F,222
No. of equity shares = !O< = 4F
= 10,000 shares
 CA Sunil Keswani FM-SM Pre-Exam Revision
Question – 7
The information related to XYZ Company Ltd. for the year ended 31st March, 2020 are as follows:
Equity Share capital of `100 each `50 lakhs
12% Bonds of `1,000 each `30 lakhs
Sales `84 lakhs
Fixed cost (excluding interest) `7.50 lakhs
Financial leverage 1.39
Profit-volume ratio 25%
Market price per equity share `200
Income tax applicable 30%
You are required to CALCULATE:
(a) Operating Leverage
(b) Combined Leverage
(c) Earnings per share
(d) Earning Yield

Solution
Income Statement
Particulars Amount (`)
Sales 84,00,000
Less: Variable cost (84,00,000 × 75%) 63,00,000
Contribution (84,00,000 × 25%) 21,00,000
Less: Fixed cost 7,50,000
EBIT 13,50,000
Less: Interest on bonds (12% × 30 lakhs) 3,60,000
Less: Other fixed interest (bal. figure) 18,777
EBT (13,50,000 ÷ 1.39) 9,71,223
Less: Tax @ 30% 2,91,367
EAT 6,79,856

%.D)>(E;)(.D 14,22,222
(a) Operating Leverage = !"#$
= 45,C2,222 = 1.56 times

(b) Combined Leverage = Operating Leverage × Financial Leverage = 1.56 × 1.39 = 2.13

!6$ B,AL,@CB
(c) Earnings per share (EPS) = 7.. .9 ?=&>,? .;)?)&D0(DH
= C2,222
= `13.597

!O< 45.CLA
(d) Earning yield = X&>Y,) '>(J, ',> ?=&>, × 100 = 122
× 100 = 6.798%
 CA Sunil Keswani FM-SM Pre-Exam Revision
Question – 8
From the following information, prepare Income Statement of Company A & B:
Particulars Company A Company B
Margin of safety 0.20 0.25
Interest `3,00 `2,000
Profit volume ratio 0 25% 33.33%
Financial Leverage 4 3
Tax rate 45% 45%

Solution
Income Statement
Particulars Company A (`) Company B (`)
Sales 80,000 36,000
(-) Variable cost 60,000 24,000
Contribution 20,000 12,000
(-) Fixed cost 16,000 9,000
EBIT 4,000 3,000
(-) Interest 3,000 2,000
EBT 1,000 1,000
(-) Tax @ 45% 450 450
EAT 550 550
Working Notes:
(i) Company A
!"#$
Financial leverage = !"#$K#D),>,?)
!"#$
4 times = !"#$K5,222
4(EBIT) - `12,000 = EBIT
EBIT = `4,000

Company B
!"#$
Financial leverage = !"#$K#D),>,?)
!"#$
3 times = !"#$K1,222
3(EBIT) - `6,000 = EBIT
EBIT = `3,000

(ii) Company A
4
Operating leverage = X&>H(D .9 <&9,)/ = 1 ÷ 0.20 = 5 times
J.D)>(E;)(.D
Operating leverage = !"#$
J.D)>(E;)(.D
5 times = F,222
Contribution = `20,000
 CA Sunil Keswani FM-SM Pre-Exam Revision

Company B
4
Operating leverage = X&>H(D .9 <&9,)/ = 1 ÷ 0.25 = 4 times
J.D)>(E;)(.D
Operating leverage = !"#$
J.D)>(E;)(.D
4 times = 5,222
Contribution = `12,000

(iii) Company A
%.D)>(E;)(.D 12,222
Sales = OW U&)(.
= 1C%
= `80,000

Company B
%.D)>(E;)(.D 41,222
Sales = OW U&)(.
= 55.55% = `36,000
 CA Sunil Keswani FM-SM Pre-Exam Revision
Question – 9
Information of A Ltd. is given below:
• Earnings after tax: 5% on sales
• Income tax rate: 50%
• Degree of operating leverage: 4 times
• 10% Debenture in capital structure: `3 lakhs
• Variable costs: `6 lakhs
Required:
(i) From the given data complete the following statement:
Sales XXXX
Less: Variable costs 6,00,000
Contribution XXXX
Less: Fixed costs XXXX
EBIT XXXX
Less: Interest expenses XXXX
EBT XXXX
Less: Income tax XXXX
EAT XXXX

(ii) Calculate Financial Leverage and Combined Leverage.

(iii) Calculate the percentage change in earning per share, if sales increased by 5%.

Solution
Let sales = y
%.D)(>E;)(.D
Degree of operating leverage = !"#$
%.D)(>E;)(.D
4= !"#$
4(EBIT) = Sales – Variable cost
4(EBIT) = Sales – 6,00,000
EBIT = 0.25(y) - 1,50,000…………………(i)
Also, given Earning after tax = 5% of sales
5% Sales = (EBIT – Interest)(1 – t)
0.05y = [0.25y – 1,50,000 – (3,00,000 10%)](1 – 0.50)
0.05y = (0.25y – 1,80,000)(0.50)
0.05y = 0.125y – 90,000
0.075y = 90,000
y = 12,00,000
Thus, EBIT = 0.25(12,00,000) – 1,50,000 = 1,50,000
Fixed cost = Contribution – EBIT = (12,00,000 – 6,00,000) – 1,50,000 = 4,50,000

Income Statement
Sales 12,00,000
Less: Variable costs 6,00,000
 CA Sunil Keswani FM-SM Pre-Exam Revision
Contribution 6,00,000
Less: Fixed costs 4,50,000
EBIT 1,50,000
Less: Interest expenses (3,00,000 10%) 30,000
EBT 1,20,000
Less: Income tax @50% 60,000
EAT 60,000
!"#$ 4,C2,222
(a) Financial Leverage = !"$
=
4,12,222
= 1.25 times
%.D)>(E;)(.D B,22,222
Combined Leverage = !"$
=
4,12,222
= 5 times
% %=&DH, (D !O<
(b) Combined Leverage = % %=&DH, (D <&*,?
% %=&DH, (D !O<
5= IC
% change in EPS = +25%
Thus, EPS increases by 25.
 CA Sunil FM-SM Pre-Exam
Keswani Revision
CAPITAL STRUCTURE - CONCEPTS
1. Capital Structure
In this company has to decide the optimal mix of capital.

2. Objectives of FM
Wealth Maximization i.e. Dividend & Capital appreciation

!"#
3. PE Ratio = $"#

EPS = PE Ratio ´ MPS

% %
4. PE Ratio = &' or Ke = "$ )*+,-

5. Statement of MPS
Particulars Plan – A Plan – B
EBIT (Operating Profit)
(-) Interest
EBT
(-) Tax
EAT
(-) Preference Dividend
EAE (Earning available for Equity)
No. of Equity Shares
MPS
 CA Sunil FM-SM Pre-Exam
Keswani Revision
6. Interest and Preference Dividend

Existing At existing rates

Interest &
Preference Dividend
New at new rates

7. Number of Equity Shares

No. of Equity Shares

Existing !"#$%&
=
'()* ,(-$*
No. of Equity shares
No. of Equity Shares
New !"#$%&
=
./ #0 1, #0 ',

8. Points to Remember (PTRs)

- EBIT will remain same for all options
- EBIT is independent of capital structure
- EBIT is dependent on amount of capital employed
- Rate of return on capital employed will remain same, unless and until specifically
mentioned in question
- New EBIT = New capital employed ´ Return on capital employed (ROCE)
./012034 .567
- Return on capital employed (ROCE) = ./012034 89:029; .<:;=>?@

- In case if MPS can’t be computed than decision will be based on EPS.

9. Indifference Level
Level of EBIT where EPS of the two options will be equal.
(.567B632?C?12)(EB2)BFC?G?C?3H? @0I0@?3@
EPS =
J=. =G ?LM02> 1N9C?1
 CA Sunil FM-SM Pre-Exam
Keswani Revision
EPS of option Debt + Equity = EPS of option Debt + Equity + PSC
(.567B632?C?12)(EB2) (.567B632?C?12)(EB2)BFC?G?C?3H? @0I0@?3@
=
J=. =G ?LM02> 1N9C?1 J=. =G ?LM02> 1N9C?1

10. In case if there are three options then solve as follows:

(i) A & B
(ii) B & C
(iii) A & C

11. To prepare graph:

Step – 1) Find indifference level
FO
Step – 2) Find financial BEP = Interest + (EB2)

Step – 3) Identify Financial BEP on X axis and should intersect at indifference level.

12. If amount of equity share capital is same under two financial plans, then one of the
following two situations will arise:
(a) No indifference point – It will arise when after tax cost of the source other than equity
shares is not same under both plans.
 CA Sunil FM-SM Pre-Exam
Keswani Revision
(b) Many indifference point – It will arise when after tax cost of the source other than
equity share is same under both plans.

13. Capital Structure Theories

14. Basic Points

!"#$%$&# !"#$%$&# !"#$%$&#
(A) Kd = '()*$ ,- .$/# = Vd =
'0 10

23!4 B!"#$%$&# 234 234

(B) Ke = '()*$ ,- 26*7#8 = Ve =
'$ 1$

(C) Vf = Ve + Vd
23!4 23!4 23!4
(D) Ko = ('$_'0) = Vf =
'- 1,

(E) If there is no debt than Ko = Ke

 CA Sunil FM-SM Pre-Exam
Keswani Revision
15. Net Income Approach

The optimum capital structure will be at a point where WACC is minimum and value of firm
is maximum i.e. use maximum debt
(1) Value of Debt = Vd
(2) Kd & Ke will be given and remain constant
.567 B632?C?12
(3) Value of Equity = Ve =
`?

(4) Vf = Vd + Ve
.567 a? a@
(5) Ko = aG
= (Ke)#aG$ + (Kd) #aG $
 CA Sunil FM-SM Pre-Exam
Keswani Revision
16. Traditional Approach

The optimum capital structure will be at a point where WACC is minimum and value of firm
is maximum.

(1) Value of Debt = Vd

(2) Kd & Ke will be given and change for different levels
.567 B632?C?12
(3) Value of Equity = Ve = `?

(4) Vf = Vd + Ve
.567 a? a@
(5) Ko = = (Ke)#aG$ + (Kd) #aG $
aG
 CA Sunil FM-SM Pre-Exam
Keswani Revision
17. Net Operating Income Approach

All options are optimum.

(1) Value of Debt = Vd
(2) Kd & Ko will be given and remain constant
.567
(3) Value of Firm = Vf =
`=

(4) Ve = Vf - Vd
.567B632?C?12
(5) Ke =
a?
 CA Sunil FM-SM Pre-Exam
Keswani Revision
18. MM Model without Tax

19. MM Model with Tax

 CA Sunil FM-SM Pre-Exam
Keswani Revision
20. Arbitrage Process

21. Trade off Theory

Tax saving on
Benefits
interest
Debt
Financial Distress
Cost
and Agency cost
 CA Sunil FM-SM Pre-Exam
Keswani Revision
22. Pecking Order Theory

IIIrd
Preference -
IInd Fresh Equity
Preference -
Debt
Ist
Preference –
Internal
Finance
 CA Sunil FM-SM Pre-Exam
Keswani Revision
CAPITAL STRUCTURE QUESTIONS
Question – 1
The particulars relating to Raj Ltd. for the year ended 31st March, 2022 are given as follows:
Output (units at normal capacity) 1,00,000
Selling price per unit `40
Variable cost per unit `20
Fixed cost `10,00,000
st
The capital structure of a company as on 31 March, 2022 is as follows:
Particulars Amount in `
Equity share capital (1,00,000 shares of `10 each) 10,00,000
Reserve and surplus 5,00,000
Current liabilities 5,00,000
Total: 20,00,000
Raj Ltd. has decided to undertake an expansion project to use the market potential that will involve
`20 lakhs. The company expects an increase in output by 50%. Fixed cost will be increase by
`5,00,000 and variable cost per unit will be decreased by 15%. The additional output can be sold at
existing selling price without any adverse impact on the market.

The following alternative schemes for financing the proposed expansion program are planned:
(Amount in `)
Alternative Debt Equity Shares
1 5,00,000 Balance
2 10,00,000 Balance
3 14,00,000 Balance
Current market price per share is `200.
Slab wise interest rate for fund borrowed is as follows:
Fund Limit Applicable interest rate
Up-to `5,00,000 10%
Over `5,00,000 and up-to `10,00,000 15%
Over `10,00,000 20%
Find out which of the above-mentioned alternatives would you recommend for Raj Ltd. with reference
to the EPS, assuming a corporate tax rate is 40%?

Solution
Calculation of EBIT
Particulars Existing Proposed
Sale units 1,00,000 1,50,000
Contribution per unit 40 – 20 = 20 40 – (20´85%) = 23
Total contribution 20,00,000 34,50,000
Less: Fixed cost 10,00,000 15,00,000
 CA Sunil FM-SM Pre-Exam
Keswani Revision
EBIT 10,00,000 19,50,000

Statement of EPS
Particulars Existing Alternative – 1 Alternative – 2 Alternative – 3
EBIT 10,00,000 19,50,000 19,50,000 19,50,000
Less: Interest - 50,000 1,25,000 [(5lakh´10%) +
(5,00,000 ´ [(5lakh´10%) + (5lakh´15%) +
10%) (5lakh´15%)] (4lakh´20%)]
EBT 10,00,000 19,00,000 18,25,000 16,95,000
Less: Tax @ 40% 4,00,000 7,60,000 7,30,000 6,78,000
EAT / EAE (A) 6,00,000 11,40,000 10,95,000 10,17,000
No. of Equity Shares
- Existing 1,00,000 1,00,000 1,00,000 1,00,000
- New - !",$$,$$$ !$,$$,$$$ &,$$,$$$
= 7,500 %$$
= 5,000 %$$
= 3,000
%$$
Total Equity Shares (B) 1,07,500 1,05,000 1,03,000
EPS (A ÷ B) 6.00 10.60 10.43 9.87
Since, Alternative – 1 has highest EPS, thus it is recommended to raise funds in combination of debt
of `5,00,000 and balance `15,00,000 from equity.
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Question – 2
Earnings before interest and tax of a company are `4,50,000. Currently the company has 80,000
Equity shares of `10 each, retained earnings of `12,00,000. It pays annual interest of `1,20,000 on
12% Debentures. The company proposes to take up an expansion scheme for which it needs additional
fund of `6,00,000. It is anticipated that after expansion, the company will be able to achieve the same
return on investment as at present. It can raise fund either through debts at rate of 12% p.a. or by
issuing Equity shares at par. Tax rate is 40%.

Required to compute the earning per share if:

(i) The additional funds were raised through debts.
(ii) The additional funds were raised by issue of Equity shares.
Advise whether the company should go for expansion plan and which sources of finance should be
preferred.

Solution
Existing capital employed = Equity + Retained Earnings + Debentures
= (80,000 ´10) + 12,00,000 + (1,20,000 ÷ 12%) = `30,00,000
Capital employed after expansion = 30,00,000 + 6,00,000 = `36,00,000
'()*+),- '/01 6,"$,$$$
New EBIT = '()*+),- 234)+35 × "#$ &'()*'+ = 7$,$$,$$$ × 36,00,000 = `5,40,000
Statement of EPS
Particulars Existing Additional fund Additional fund
as debt as equity
EBIT 4,50,000 5,40,000 5,40,000
Less: Interest
- Existing Debt 1,20,000 1,20,000 1,20,000
- New Debt - 72,000 -
EBT 3,30,000 3,48,000 4,20,000
Less: Tax @ 40% 1,32,000 1,39,200 1,68,000
EAT/EAE (A) 1,98,000 2,08,800 2,52,000
No. of Equity shares (B) 80,000 80,000 1,40,000
EPS (A ÷ B) 2.475 2.610 1.800
EPS is higher when the additional funds are raised through debt, thus it is the recommended option for
the company.
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Question – 3
Akash Limited provides you the following information:
Amount (`)
Profit (EBIT) 2,80,000
Less: Interest on Debentures @ 10% (40,000)
EBT 2,40,000
Less: Income Tax @ 50% (1,20,000)
1,20,000
No. of Equity shares (`10 each) 30,000
Earnings per share (EPS) 4
Price /EPS – (PE Ratio) 10
The company has reserves and surplus of `7,00,000 and required `4,00,000 further for modernization.
Return on Capital Employed (ROCE) is constant. Debt (Debt/ Debt + Equity) Ratio higher than 40%
will bring the P/E Ratio down to 8 and increase the interest rate on additional debts to 12%. You are
required to ascertain the probable price of the share.
(a) if the additional capital is raised as debt; and
(b) if the amount is raised by issuing equity shares at ruling market price.

Solution
Statement of MPS
Particulars Debt Option (`) Equity Option (`)
EBIT 3,60,000 3,60,000
Less: Interest on old deb. 40,000 40,000
Less: Interest on new debt (4,00,000 × 12%) 48,000 -
EBT 2,72,000 3,20,000
Less: Taxes @ 50% 1,36,000 1,60,000
EAT/EAE 1,36,000 1,60,000
Number of equity shares 30,000 40,000
Earning per share (EPS) 4.53 4.00
PE Ratio 8 10
Market Price Per Share (EPS × PE Ratio) 36.24 40
Option II of raising funds with equity is better.

Working Note:
1) Existing capital = Equity + 10% Debentures + Reserve & Surplus
= (30,000×10) + (40,000 ÷ 10%) + 7,00,000 = `14,00,000
%,8$,$$$
Rate of present earnings = !6,$$,$$$ × 100 = 20%
New capital employed = 14,00,000 + 4,00,000 = `18,00,000
New EBIT = 18,00,000 × 20% = `3,60,000

2) Option I
9:;+ 6,$$,$$$<6,$$,$$$
Debt Equity Ratio = 9:;+<'=>)+? = !8,$$,$$$
× 100 = 44.44%
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Since Debt Equity Ratio is more than 40%, thus PE ratio will be down to 8.
Option II
9:;+ 6,$$,$$$
Debt Equity Ratio = 9:;+<'=>)+? = !8,$$,$$$ × 100 = 22.22%
Since Debt Equity Ratio is less than 40%, thus PE ratio will remain same at 10.
 CA Sunil FM-SM Pre-Exam
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Question - 4
ER Private Limited has a paid-up capital ₹2,50,000 consisting of 25,000 Equity shares of ₹10 each.
The Market price per share is ₹24 with PE ratio of 8. The company is planning to purchase a plant
which will cost ₹5,00,000. This plant is expected to yield earnings before interest and taxes of
₹2,00,000 per annum. It has two alternatives to finance the plant
Alternatives Equity Debt
A 100% –
B 50% 50%
Other information is as under:
(i) Cost of debt is 12%.
(ii) Equity shares of face value of ₹10 each will be issued at a premium of ₹10 per share.
(iii) PE ratio of Leveraged company will be 7.
(iv) Tax rate -40%.
Advise which alternative is the most suitable to raise the funds for additional capital, keeping in
mind to maximize the benefit to its Shareholders.

Solution
Present EPS = MPS ÷ PE Ratio = 24 ÷ 8 = `3
Present EAT = EPS ´ No. of Equity Shares = 3 ´ 25,000 = `75,000
Present EBIT = EAT ´ (1 – t) = 75,000 ÷ ( 1 – 0.40) = `1,25,000
New EBIT = 1,25,000 + 2,00,000 = `3,25,000
Particulars Existing Alternative A Alternative B
EBIT 1,25,000 3,25,000 3,25,000
Less: Interest - - 30,000
EBT 1,25,000 3,25,000 2,95,000
Less: Tax @ 40% 50,000 1,30,000 1,18,000
EAT 75,000 1,95,000 1,77,000
No. of equity shares 25,000 ",$$,$$$ %,"$,$$$
25,000 + %$
= 25,000 + %$
=
50,000 37,500
EPS 3 3.90 4.72
PE Ratio 8 8 7
MPS 24 31.20 33.04
Alternative B i.e. issue of 12% Debentures is most suitable to maximize the market price per share.
 CA Sunil FM-SM Pre-Exam
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Question – 5
J Ltd. is considering three financial plans. The key information is as follows:
(i) Total investment to be raised `4,00,000.
(ii) Plans of Financing
Plans Equity Debt Preference Shares
X 100% - -
Y 50% 50% -
Z 50% - 50%
(iii) Cost of Debt – 10%
Cost of preference shares – 10%
(iv) Tax rate is 50%
(v) Equity shares of the face value of `10 each will be issued at a premium of `10 per share
(vi) Expected EBIT is `1,00,000
You are required to compute the following for each plan:
(a) Earnings per share (EPS)
(b) Financial break-even point
(c) Indifference Point between the plans and indicate if any of the plans dominate.

Solution
(a) Computation of Earnings Per Share (EPS)
Particulars Plan X Plan Y Plan Z
EBIT 1,00,000 1,00,000 1,00,000
Less: Interest on debt - 20,000 -
EBT 1,00,000 80,000 1,00,000
Less: Tax @ 50% 50,000 40,000 50,000
EAT 50,000 40,000 50,000
Less: Preference Dividend - - 20,000
EAE (A) 50,000 40,000 30,000
No. of equity shares (B) 20,000 10,000 10,000
EPS (A ÷ B) 2.50 4.00 3.00

(b) Computation of Financial Break-even Point

@A:B:A:,C: 9)D)E:,E
Plan X – Financial BEP = Interest + (!G+)
= 0 + 0 = `0
@A:B:A:,C: 9)D)E:,E
Plan Y – Financial BEP = Interest + (!G+)
= 20,000 + 0 = `20,000
@A:B:A:,C: 9)D)E:,E %$,$$$
Plan Z – Financial BEP = Interest + (!G+)
= 0 + (!G$."$) = `40,000

(c) Indifference point

Between Plan X and Y
('/01G$)(!G$."$)G$ ('/01G%$,$$$)(!G$."$)G$
%$,$$$
= !$,$$$
$."('/01) $."('/01G%$,$$$)
%$,$$$
= !$,$$$
EBIT = 2(EBIT) – 40,000
 CA Sunil FM-SM Pre-Exam
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EBIT = `40,000

Between Plan Y and Z

('/01G%$,$$$)(!G$."$)G$ ('/01G$)(!G$."$)G%$,$$$
!$,$$$
= !$,$$$
$."('/01G%$,$$$) $."('/01)G%$,$$$
!$,$$$
= !$,$$$
0.5(EBIT) – 10,000 = 0.5(EBIT) – 20,000
There is no indifference point between Plan Y and Z.

Between Plan X and Z

('/01G$)(!G$."$)G$ ('/01G$)(!G$."$)G%$,$$$
%$,$$$
= !$,$$$
$."('/01) $."('/01)G%$,$$$
%$,$$$
= !$,$$$
0.5(EBIT) = EBIT – 40,000
EBIT = `80,000
The above indifference levels are presented in the following table:
Expected Level of EBIT Recommended plan
Less than `40,000 Plan X
Equal to `40,000 Plan X or Plan Y
Between `40,000 to `80,000 Plan Y
More than `80,000 Plan Y
From the above table, it can be clearly observed that Plan Y is more dominating than other plans.
 CA Sunil FM-SM Pre-Exam
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Question – 6
XYZ Ltd. is considering the following two alternative financing plans:
Particulars Plan A Plan B
Equity Shares of `10 each 8,00,000 8,00,000
12% Debentures 4,00,000 -
Preference shares of `100 each - 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
At indifference level i.e. when EBIT = `4,80,000
EPS of Plan A = EPS of Plan B
('/01G),+:A:*+)(!G+) ('/01G),+:A:*+)(!G+)G@9
JK.KB :=>)+? *L3A:*
= JK.KB :=>)+? *L3A:*
(6,8$,$$$G68,$$$)(!G$.7$) (6,8$,$$$G$)(!G$.7$)G@9
8$,$$$
= 8$,$$$
3,02,400 = 3,36,000 – PD
PD = `33,600
@9 77,&$$
Rate of preference dividend = @A:B. *L. C34)+35
× 100 = 6,$$,$$$ × 100 = 8.40%
 CA Sunil FM-SM Pre-Exam
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Question – 7
A Limited and B Limited are identical except for capital structures. A Ltd. has 60% debt and 40%
equity, whereas B Ltd. has 20% debt and 80% equity. (All percentages are in market-value terms). The
borrowing rate for both companies is 8% in a no-tax world, and capital markets are assumed to be
perfect.
(a) (i) If X owns 3% of the equity shares of A Ltd. determine his return if the company has net
operating income of `4,50,000 and the overall capitalization rate of the company, (Ko) is
18%.
(ii) Calculate the implied required rate of return on equity of A Ltd.
(b) B Ltd. has the same net operating income as A Ltd.
(i) Calculate the implied required equity return of B Ltd.
(ii) Analyze why does it differ from that of A Ltd.

Solution
'/01 6,"$,$$$
(a) (i) Value of A Ltd. = MK
= !8%
= `25,00,000
Value of Debt = `25,00,000 × 60% = `15,00,000
Value of Equity = `25,00,000 × 40% = `10,00,000

Income Statement
EBIT 4,50,000
Less: Interest (15,00,000 × 8%) 1,20,000
EBT / EAT / EAE 3,30,000
Return on 3% shares of Mr. X = `3,30,000 × 3% = `9,900

'O' 7,7$,$$$
(ii) Implied rate of return on equity = P35>: KB :=>)+? × 100 = !$,$$,$$$ × 100 = 33%

'/01 6,"$,$$$
(b) (i) Value of B Ltd. = M:
= !8%
= `25,00,000
Value of debt = `25,00,000 × 20% = `5,00,000
Value of equity = `25,00,000 × 80% = `20,00,000

Income Statement
EBIT 4,50,000
Less: Interest (5,00,000 × 8%) 40,000
EBT / EAT / EAE 4,10,000

'O' 6,!$,$$$
Implied rate of return on equity = P35>: KB :=>)+? × 100 = %$,$$,$$$ × 100 = 20.50%

(ii) It is lower than the A Ltd. because B 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.
 CA Sunil FM-SM Pre-Exam
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Question – 8
SK Ltd. has a total capitalization of `10,00,000. The financial manager of the firm wants to take a
decision regarding the capital structure. After a study of the capital market, he gathers the following
data:
Amount of Debt Interest Rate Equity Capitalization Rate
` % (at given level of debt) %
0 - 10.0
1,00,000 4.0 10.5
2,00,000 4.0 11.0
3,00,000 4.5 11.6
4,00,000 5.0 12.4
5,00,000 5.5 13.5
6,00,000 6.0 16.0
(a) What amount of debt should be employed by the firm if the traditional approach is held valid (and
that the firm always maintains its capital structure at book values)?
(b) If the Modigliani-Millar approach is followed, what should be the equity capitalization rate?
Solution
Value Value of Weight Weight of Kd Ke Part (a) Part (b)
of Debt Equity of Debt Equity Ko* Kel**
(Wd) (We)
0 10,00,000 0 1 - 10.0 (0×0) + (1×10) 10 + (10 – 0)(0÷1)
= 10.0 = 10
1,00,000 9,00,000 0.10 0.90 4.0 10.5 (0.1×4) + 10 + (10 –
(0.9×10.5) = 4)(0.1÷0.9) =
9.85 10.67
2,00,000 8,000,000 0.20 0.80 4.0 11.0 (0.2×4) + 10 + (10 –
(0.8×11) = 9.6 4)(0.2÷0.8) = 11.5
3,00,000 7,00,000 0.30 0.70 4.5 11.6 (0.3×4.5) + 10 + (10 –
(0.7×11.6) = 4.5)(0.3÷0.7) =
9.47 12.36
4,00,000 6,00,000 0.40 0.60 5.0 12.4 (0.4×5) + 10 + (10 –
(0.6×12.4) = 5)(0.4÷0.6) =
9.44 13.33
5,00,000 5,00,000 0.50 0.50 5.5 13.5 (0.5×5.5) + 10 + (10 –
(0.5×13.5) = 9.5 5.5)(0.5÷0.5) =
14.5
6,00,000 4,00,000 0.60 0.40 6.0 16.0 (0.6×6) + 10 + (10 –
(0.4×16) = 10.0 6)(0.6÷0.4) = 16
*Ko = (Wd×Kd) + (We×Ke)
 CA Sunil FM-SM Pre-Exam
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**Kel = Keu + (Keu – Kd)(Wd÷We)
As per the traditional approach, the optimal debt equity mix will be at the level at which overall cost
of capital (Ko) is minimum which is achieved when company employs debt of `4,00,000 and equity
of `6,00,000.
 CA Sunil FM-SM Pre-Exam
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Question – 9
The following data relate to two companies belonging to the same risk class:
Particulars A Ltd. B Ltd.
Expected Net Operating Income `18,00,000 `18,00,000
12% Debt `54,00,000 -
Equity Capitalization Rate - 18%

Required:
(a) Determine the total market value, equity capitalization rate and weighted average cost of capital
for each company assuming no taxes as per MM approach
(b) Determine the total market value, equity capitalization rate and weighted average cost of capital
for each company assuming 40% taxes as per MM approach.

Solution
'/01 !8,$$,$$$
(c) Value of B Ltd. (Unlevered firm) = M:
= !8%
= `1,00,00,000
Value of A Ltd. (Levered firm) = Value of B Ltd. + Tax benefit
= 1,00,00,000 + (54,00,000 × 0) = `1,00,00,000

Ke of B Ltd. = 18% (given)

'/01G0,+:A:*+ !8,$$,$$$G("6,$$,$$$×!%%) !!,"%,$$$
Ke of A Ltd. = P35>: BK '=>)+? = !,$$,$$,$$$ G"6,$$,$$$
= 6&,$$,$$$ = 0.2504 = 25.04%

WACC of B Ltd. = Ke = 18%

WACC of A Ltd.
Source Amount Weights Cost of capital Weighted Average Cost
(1) (2) (3) (4) (5)= (3)x(4)
Equity 46,00,000 0.46 25.04 11.52
Debt 54,00,000 0.54 12.00 6.48
1 18
Weighted Average Cost of Capital (WACC) = 18%

'/01(!G+) !8,$$,$$$(!G$.6$)
(d) Value of B Ltd. (Unlevered firm) = M:
= !8%
= `60,00,000
Value of A Ltd. (Levered firm) = Value of B Ltd. + Tax benefit
= 60,00,000 + (54,00,000 × 0.40) = `81,60,000

Ke of B Ltd. = 18% (given)

('/01G0,+:A:*+)(!G+) [!8,$$,$$$G("6,$$,$$$×!%%)](!G$.6$) &,T!,%$$
Ke of A Ltd. = P35>: BK '=>)+?
= 8!,&$,$$$ G"6,$$,$$$
= %U,&$,$$$ = 25.04%

WACC of B Ltd. = Ke = 18%

Kd of A LTd. = I × (1 – t) = 12 × (1 – 0.40) = 7.20%
 CA Sunil FM-SM Pre-Exam
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WACC of A Ltd.
Source Amount Weights Cost of capital Weighted Average Cost
(1) (2) (3) (4) (5)= (3)x(4)
Equity 27,60,000 0.34 25.04 8.51
Debt 54,00,000 0.66 7.20 4.75
1 13.26
Weighted Average Cost of Capital (WACC) = 13.26%
 CA Sunil FM-SM Pre-Exam
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Question – 10
Rounak Ltd. is an all equity financed company with a market value of `25,00,000 and cost of equity
(Ke) 21%. The company wants to buyback equity shares worth `5,00,000 by issuing and raising 15%
perpetual debt of the same amount. Rate of tax may be taken as 30%. After the capital restructuring
and applying MM model (with taxes), you are required to COMPUTE:
(a) Market value of the company
(b) Cost of equity
(c) Weighted average cost of capital (using market weights) and comment on it.

Solution
Working Note:
J:+ 0,CKV: (J0)BKA '=>)+? WK5E:A*
Market value of equity = M:
J:+ 0,CKV: (J0)BKA '=>)+? WK5E:A*
`25,00,000 = $.%!
Net Income for Equity Holders = 25,00,000 × 0.21 = `5,25,000
",%",$$$
EBIT = !G$.7$
= `7,50,000
(`in lakhs)
Particulars All Equity Debt and Equity
EBIT 7,50,000 7,50,000
(-) Interest - (75,000)
EBT 7,50,000 6,75,000
(-) Tax @ 30% 2,25,000 2,02,500
Income to shareholders 5,25,000 4,72,500

(a) Market value of company = Value of equity + Value of debt

= `25,00,000 + (5,00,000 × 0.30) = `26,50,000
The impact is that the market value of the company has increased by `1,50,000.

J:+ ),CKV: +K :=>)+? LK5E:A* 6,U%,"$$

(b) Ke = '=>)+? D35>:
= %&,"$,$$$G",$$,$$$ = 0.219 = 21.98%

(c) Kd = I × (1 – t) = 15% × (1 – 0.30) = 10.5%

Weighted Average Cost of Capital (WACC)

Source Amount Weights Cost of capital Weighted Average Cost
(1) (2) (3) (4) (5)= (3)x(4)
Equity 21,50,000 0.81 21.98 17.80
Debt 5,00,000 0.19 10.50 2.00
26,50,000 1 19.80
Weighted Average Cost of Capital (WACC) = 19.80%
The impact is that WACC has fallen by 1.20% due to benefit of lower cost of capital of debt.
 CA Sunil FM-SM Pre-Exam
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Question - 11
Company P and Q are identical in all respects including risk factors except for debt/equity, company
P having issued 10% debentures of `18 lakhs while company Q is unlevered. Both the companies earn
20% before interest and taxes on their total assets of `30 lakhs.

Assuming a tax rate of 50% and capitalization rate of 15% from an all-equity company.
Required to calculate the value of companies P and Q using (a) Net Income Approach and (b) net
Operating Income Approach.

Solution
(a) Valuation under Net Income Approach
Particulars P (` ) Q (` )
EBIT (30,00,000×20%) 6,00,000 6,00,000
Less: Interest (18,00,000×10%) 1,80,000 -
EBT 4,20,000 6,00,000
Less: Tax @ 50% 2,10,000 3,00,000
EAT/EAE 2,10,000 3,00,000
Value of Equity (Ve = EAE÷15%) 14,00,000 20,00,000
Add: Total value of debt (Vd) 18,00,000 -
Total value of company (Ve+Vd) 32,00,000 20,00,000

(b) Valuation under Net Operating Income Approach

'/01(!G+) &,$$,$$$×(!G$."$)
Value of Firm Q (unlevered) = M:
= !"%
= `20,00,000
Value of Firm P (levered) = Value of unlevered firm + (Debt × Tax rate)
= 20,00,000 + (18,00,000×50%) = `29,00,000
 CA Sunil FM-SM Pre-Exam
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Question – 12
The following is the data regarding two companies S and K belonging to the same risk class:
Company S Company K
Number of ordinary shares 90,000 1,50,000
Market price per share (`) 1.20 1.00
6% Debentures (`) 60,000 --
Profit before interest (`) 18,000 18,000
All profits after debenture interest are distributed as dividends. Explain how under Modigliani & Miller
approach, an investor holding 10% shares in company S will be better off in switching his holding to
Company K.

Solution
Particulars Company S Company K
Value of Equity 90,000×1.20 = 1,08,000 1,50,000×1 = 1,50,000
Value of Debt 60,000 -
Total value of Firm 1,68,000 1,50,000
Value of levered company S is more than unlevered company therefore investor will sell his shares in
Company S and buy shares of Company K. To maintain the risk level i.e. Debt & equity ratio, he will
borrow proportionate amount and invest that in shares of company K.

Investment & Borrowings:

Sell value from shares of Company S (1,08,000 ´ 10%) `10,800
Borrow money (60,000 ´ 10%) `6,000
Buy shares of Company K `16,800

Earning of Investor
!8,$$$
Income from shares of Company K 1!,"$,$$$ × 16,8003 `2,016

Less: Interest on loan (6,000 ´ 6%) `360

Net income from Company K `1,656
Less: Income from Company S (12,000 ´ 10%) `1,440
Incremental gain due to arbitrage `216
 CA Sunil FM-SM Pre-Exam
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Question – 13
The following data relate to two companies belonging to the same risk class:
Particulars S Ltd. K Ltd.
Expected Net Operating
Income `2,40,000 `2,40,000
10% Debt `7,20,000 -
Equity Capitalization Rate 20% 15%
Required:
(a) Determine the total value and the weighted average cost of capital for each company assuming no
taxes before the start of arbitrage process.
(b) Show the arbitrage process by which an investor who holds 10% equity share in K Ltd. will be
benefited by investing in S Ltd.
(c) When will this arbitrage process come to an end?

Solution
(a) Statement of calculation of value of firm
Particulars Company S Company K
EBIT 2,40,000 2,40,000
(-) Interest 72,000 -
EBT 1,68,000 2,40,000
Ke 20% 15%
Ve !,&8,$$$ %,6$,$$$
%$%
= 8,40,000 !"%
= 16,00,000
Vd 7,20,000 -
Vf 15,60,000 16,00,000
Ko %,6$,$$$ %,6$,$$$
!",&$,$$$
× 100 = 15.385% !&,$$,$$$
× 100 = 15%

(b) Value of Company K (unlevered) is more than of Company S (Levered). Thus, investor will sell
shares in Company K and buy shares of Company S. To maintain the level of risk i.e. Debt and Equity
ratio(7.2 : 8.4), he will lend proportionate amount and invest balance amount in shares of company K.

Investment & Borrowings:

Sale value from shares of Company K (16,00,000 ´ 10%) `1,60,000
Lend money [1,60,000 ´ (7.2 ÷ 15.6)] `73,846
Buy shares of Company S [1,60,000 ´ (8.4 ÷ 15.6)] `86,154
`1,60,000
 CA Sunil FM-SM Pre-Exam
Keswani Revision
Earning of Investor
!,&8,$$$
Income from shares of Company S 18,6$,$$$ × 86,1543 `17,231

Add: Interest from loan given (73,846 ´ 10%) `7,385

Net income from Company S `24,616
Less: Income from Company K (2,40,000 ´ 10%) `24,000
Incremental gain due to arbitrage `616

(d) The arbitrage process will come to an end when the value of both firms i.e. S and K becomes equal.