Capital structure, cost of capital and value

Question Bank Prof. Prapti Paul

1) XYZ ltd. has EBIT of Rs. 4,00,000. the firm currently has outstanding debts of Rs.15,00,000 at an avg. cost of , kd of 10%. Its ke is estimated to be 16%. I. Determine the current market value of the firm using traditional valuation approach II. Determine the firms overall capitalization rate, ko. III. The firm is considering to issue capital of Rs.5,00,000 in order to redeem Rs.5,00,000 debt. The cost of debt is expected to be unaffected. However the firms cost of equity capital is to be reduced to 14% as a result of decrease in leverage. Would you recommend the proposed action? ( answer: Total market value Rs. 30,62,500, ko=13.1% and proposal shd be accepted.)
2) NOI Ltd. belongs to a risk class of 10% and expects EBIT of Rs.4,00,000. it employs 8% debt in the capital structure. Find out the value of the firm and the cost of equity capital, ke, if it employs deb to the extent of 20%, 35% or 50% of the total financing requirement of Rs.20,00,000. (answer: value of firm at 20% debt= Rs.40,00,000; ke= 10.22% value of firm at 35% debt = Rs. 40,00,000; ke= 10.42% value of firm at 50% debt = Rs. 40,00,000; ke= 10.67%)

3) A steel Ltd. has employed 15% debt of Rs.12,00,000 in its capital structure. The NOI of the firm is Rs.5,00,000 and has a equity capitalization ratio of 16%. Assuming that there is no tax, find out the value of the firm under NI Approach. ( answer : value of the firm Rs.32,00,000). 4) The NOP of a firm is Rs.2,10,000 and the total market value of its 12% debt is Rs.3,00,000. The equity capitalization rate of an unlevered firm of the same risk class is 16%. Find out the value of the levered firm given that the tax rate is 30% for both the firms. ( answer: Rs.10,08,750). 5) S Ltd. and T ltd. are in the same risk class and are identical in all respects except that the co. S uses debt while the co. T does not use debt. The levered firm has Rs.9,00,000 debentures carrying 10% rate of interest. Both the firms earn 20% operating profit on their total assets of Rs.15 lacs. The co. is in the tax bracket of 35% and the capitalization rate of 15% on all equity shares. Compute the value of S Ltd. and T Ltd. Using Net Income Approach. ( answer: Rs.18,10,000 and Rs.13,00,000 resp.)

6) The foll is the data regarding 2 cos. X& Y belonging to the same risk class: Co. X No. of eq. sh. Market price per share (Rs.) 6% debentures (Rs.) 90,000 1.20 60,000 Co. Y 1,50,000 1.00 ---

Profit before interest (Rs.) 18,000 18,000 All profits after debenture interest are distributed as dividends. Explain how under MM approach , an investor holding 10% of shares in Co. X will be better off in switching his holding to Co. Y.

7) From the foll selected data, determine the value of the firms ,P &Q belonging to the homogeneous risk class under: (a) NI Approach (b) NOI Approach. Which of the firms has an optimal capital structure under each approach.
Firm P EBIT (Rs.) Interest at 15% Ke Tax rate 2,25,000 75,000 20% 50% Firm Q 2,25,000 ----20% 50%

8) Two cos., X and Y belong to the equivalent risk group. The 2 cos. are identical in every respect except that the co. Y is levered while X is unlevered. The outstanding amount of debt of the levered co. is Rs.6,00,000 in 10% debenture. Other info is as foll: X Net operating income (EBIT) Rs. - Interest Earnings to equity sh.hol Ke 1,50,000 ----1,50,000 .15 Y 1,50,000 60,000 90,000 .20

Market value of equity

Market value of debt Total value of firm , V Overall capitalization rate ko= EBIT/V Debt equity ratio

10,00,000
-----10,00,000 15% 0

4,50,000
6,00,000 10,50,000 14.3% 1.33

An investor owns 5% equity shares of co.Y. Show the process and the amount by which he could reduce his outlay through the use of arbitrage process. Is there any limit to the process?

9) K Ltd. has 10,00,000 equity shares of Rs. 10 each and 10% debentures of Rs. 14,00,000. the equity shares are traded at Rs.24 per share and the debentures at par value. The return on equity shares is 20%. Find out the equity rate of return applying the MM Model ( without taxes). (answer ke= 16.31%)

Capital structure: planning and designing

1) Foll is the income statement of Aakash Ltd. : Rs. In crores Sales COGS includes depreciation Selling & admin expenses EBIT Taxes @35% Net income 500 250 50 200 70 130

The co.s cost of capital is 11% and its net assets are worth Rs.800 crores. i) What is the conventional return on investment? ii) What is the net addition to the wealth of sh.hol in the current year in terms of economic value added? ( answer: ROI= 16.25% and EVA= Rs.42 crores).

2) Alpha co. is contemplating conversion of 500, 14% convertible bonds of Rs.1,000 each. Market price of the bond is Rs.1,080. bond indenture provides that 1 bond will be exchanged for 10 shares. P/E ratio before redemption is 20:1 and anticipated P/E ratio after redemption is 25:1. No. of shares outstanding prior to redemption are 10,000 shares. EBIT amounts to Rs.2,00,000. The co. is in the 35% tax bracket. Should the co. convert bonds into shares? Give reasons. 3) G Motors Ltd., a producer of turbine generators, is in this situation : EBIT = Rs.40 lakhs; tax rate=T=35%; debt outstanding =D=Rs.20 lakhs; rate of interest= 10%; ke= 15%; shares of stock outstanding =No.=6,00,000; book value per share= Rs. 10. since Gs product market is stable and the co. expects no growth, all earnings are paid out of dividends. The debt consists of perpetual bonds. What is the Gs EPS and price per share Po? G can increase its debt by Rs.80 lakhs, to a total of Rs.1 crore, using the new debt to buy back and retire some of its shares at the current price. Its interest rate on debt will be 12% ( it will have to call and refund the old debt), and its cost of equity will rise from 15% to 17%. EBIT will remain constant. Should G change its capital structure?