SOLUTIONS TO ASSIGNMENT PROBLEMS. Problem No.1. Decision: since the WACC is minimum 20% of debt and 80% equity represents optimum capital structure.

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1 Ph: /6 SOLUTIOS TO ASSIGMT PROBLMS Problem o. valuation of different capital structures given in the problem: 5. CAPITAL STRUCTUR % of debt % of equity Cost of debt(k i ) Cost of equity(k e ) WACC (K O ) 0% 00% 6%.5%.5% 0% 90% 6% % 6*0%+*90%.4% 0% 80% 6% % 6*0%+*80%0.8% 30% 70% 6.5% 3% 6.5*30%+3*70%.05% 40% 60% 7% 5% 7*40%+5*60%.8% 50% 50% 7.5% 7%.5% 60% 40% 8% 0%.8% Decision: since the WACC is minimum 0% of debt and 80% equity represents optimum capital structure. Problem o. Calculation of PS under all the three options (Rs. In Lakhs) quity Debt Option I Option II Option III.5.5 BIT Less: Interest (.5 X 0%) 0.5 (.5X0%+75X5%).375 (.375+5X0%).375 BT Less: 50% IPCC_33e_Costing_Capital Structure_Assignment Solutions AT /ASH (A) o. of shares (B) PS (A/B) Conclusion: The objective of the financial management is to maximize the benefits of equity share holders. Since PS is maximum in option II, it is beneficial to raise the required funds of 5,00,000 as 5,00,000 through equity and 0,00,000 through debt. BIT - xisting - ew Problem o.3 Statement showing the selection of best finance option Debt quity 3,000 5,000 3,000 5,000 Total BIT 46,000 46,000 Less: Interest - xisting - ew BT Less: 35% (ote),000 (0KX7%) 3,500 (50000X7%) 4,500 4,55,000 < 45,000 5,750

2 o. for CA/CWA & MC/CC MASTR MIDS AT /ASH (A) 6,975 9,50 o. of shares xisting - ew PS (A / B) P ratio MP (PS X P ratio) 5,000-5,000 50,000,000 5 (B) 5,000 7, ,500 ote: Income Tax rate 00 35% 30,000 Conclusion: Since Market Price higher, in case of debt, it is the best capital structure. Problem o Calculation of interest coverage ratio (Rs. in Lakhs) Before Additional borrowings After Additional borrowings BIT (A) 6.4 (X0%) Interest on term loan (40 X %) Interest on bank borrowings (30X6%) Interest on public deposit (5X%) Interest on additional Bank borrowing IPCC_33e_F.M_Capital Structure_Assignment Solutions (5X6%) Total interest (B) 5 Interest Coverage Ratio (A/B) times.76 times Conclusion: The interest coverage ratio has decrease from times to.76 times. This is not a favourable situation for money lender / creditor. Problem o.5 valuation of the given four financial plans on the basis of PS (Rs. in lakhs) Option A Option B Option C Option D xisting equity share capital Fresh issue of equity Debt Preference shares Option A Option B Option C Option D BIT Less: interest -.8(0*9%) 3.0(30*0%) - BT Less: 50% AT/ASH Less: preference dividend.5(0*7.5%) ASH(A) o. of equity shares xisting(40/00) W 0.4(40/00) 0.(0/00) 0.(0/00) 0.(0/00) Total (B) PS (A/B)

3 Ph: /6 The objective of financial management is to maximize the benefits of equity share holders; since PS is maximum it is beneficial to raise the required amount of 40 lakhs by issuing 0,000 equity shares Rs.00 each and 30 lakhs through long term borrowing with interest 30%. Problem o.6 Statement of calculation of earnings available to equity holders and debt holders et operating income Less: Interest on Debt (% of Rs.7,00,000) Profit before taxes Less: 5% Profit after tax/arnings available in equity holders Total earnings available to equity holders + Debt holders Company A 5,00,000-5,00,000 3,75,000,5,000,5,000 B 5,00,000 77,000 4,3,000 3,55,750 0,67,50 0,67,50+77,000,44,50 As we can see that the earnings in case of Company B is more than the earnings of Company A because of tax shield available to shareholders of Company B due to the presence of debt structure in Company B. The interest is deducted from BIT without tax deduction at the corporate level; equity holders also get their income after tax deduction due to which income of both the investors increase to the extent of tax saving on the interest paid i.e. tax shield i.e.5% 77,000 9,50 i.e. difference in the income of two companies earnings i.e.,44,50,5,000 Rs.9,50. The PS is determined as follows: Problem o.7 BIT Interest PBT Taxes at 50% PAT o.of shares PS I (Rs.,00,000 debt),60,000 8,000,5,000 76,000 76,000 36,000. Alternatives II (Rs.4,00,000 debt),60,000 44,000,6,000 58,000 58,000 4,000.4 III (Rs.6,00,000 debt),60,000 74,000 86,000 43,000 43,000 0,000.5 The second alternative maximizes PS; therefore, it is the best financial alternative in the present case. The interest charges for Alternative II and III are calculated as follows: Interest calculation, Alternative II,00,000@8% 3,00,000@% Total Interest calculation, Alternative III,00,000@8% 4,00,000@%,00,000@8% Total Amount 8,000 36,000 44,000 Amount 8,000 48,000 8,000 74,000 IPCC_33e_Costing_Capital Structure_Assignment Solutions 34

4 o. for CA/CWA & MC/CC MASTR MIDS The number of shares is found out by dividing the amount to be raised through equity issue by the market price per share. The market price per share is Rs.5 in case of first two alternatives and Rs.0 in case of last alternative. Problem o.8 Let X represents level of BIT at which PS is same under both the options. ( x 0)( 35% ) (X 00LX5%)( 35%) 300L/00 00L/00 X(65%) (X 5L)65% 3L L X 3X-45,00,000 X 45,00,000 BIT Rs. 45,00,000 Conclusion: If BIT is 45lakhs then PS will be same under both the options i.e., Rs per share. Problem o.9 Alternatives in financing and its financial charges. a. By issue of 6,00,000 equity shares of Rs.0 each amounting to Rs.60 lakhs. o financial charges are involved. b. By raising the funds in the following way: Debt Rs.40 lakhs quity Rs.0 lakhs (,00,000 equity shares of Rs.0 each) 8 Interest payable on debt 4,00,000X Rs.7,0, The difference point between the two alternatives is calculated by: ( BIT l )( T) (BIT l )( T) Where, BIT arning before interest and taxes I Interest charges in Alternative (a) I Interest charges in Alternative (b) T Tax rate quity shares in Alternative (a) quity shares in Alternative (b) Putting the values, the break-even point would be as follows: ( BIT 0)( 0.40) (BIT 7,0,000)( 0.40) 6,00,000,00,000 ( BIT)(0.60) (BIT 7,0,000)(0.60) 6,00,000,00,000 ( BIT)(0.60) (BIT 7,0,000)(0.60) 3 BIT 3BIT,60,000 - BIT,60,000,60,000 BIT BIT 0,80,000 Therefore, it can be seen that the BIT at indifference point explains that the earnings per share for the two alternatives is equal. IPCC_33e_F.M_Capital Structure_Assignment Solutions 35

5 Ph: /6 Problem o.0 i. Computation of PS under three-financial plans. Plan : quity Financing BIT Rs. 6,500 Rs.,5,000 Rs.,50,000 Rs. 3,75,000 Rs. 6,5,000 Interest BT Rs. 6,500 Rs.,5,000 Rs.,50,000 Rs. 3,75,000 Rs. 6,5,000 Less: Taxes 40% 5,000 50,000,00,000,50,000,50,000 PAT Rs. 37,500 Rs. 75,000 Rs.,50,000 Rs.,5,000 Rs. 3,75,000 o. of equity shares 3,,500 3,,500 3,,500 3,,500 3,,500 PS Rs Plan : Debt quity Mix BIT Rs. 6,500 Rs.,5,000 Rs.,50,000 Rs. 3,75,000 Rs. 6,5,000 Interest,5,000,5,000,5,000,5,000,5,000 BT (6,500) 0,5,000,50,000 5,00,000 Less: Taxes 40% 5,000* 0 50,000,00,000,00,000 PAT (37,500) 0 75,000,50,000 3,00,000 o. of equity shares,56,50,56,50,56,50,56,50,56,50 PS (Rs. 0.4) The Company will be able to set off losses against other profits. If the Company has no profits from operations, loses will be carried forward. Plan 3: Preference Shares quity Mix BIT Rs. 6,500 Rs.,5,000 Rs.,50,000 Rs. 3,75,000 Rs. 6,5,000 Interest BT Rs. 6,500 Rs.,5,000 Rs.,50,000 Rs. 3,75,000 Rs. 6,5,000 Less: Taxes 40% 5,000 50,000,00,000,50,000,50,000 PAT Rs. 37,500 Rs. 75,000 Rs.,50,000 Rs.,5,000 Rs. 3,75,000 Less: Pref. dividend,5,000,5,000,5,000,5,000,5,000 PAT for ordinary (87,500) (50,000) 5,000,00,000,50,000 Shareholders o. of equity shares,56,50,56,50,56,50,56,50,56,50 PS (0.56) (0.3) ii. The choice of the financing plan will depend on the state of economic conditions. If the company s sales are increasing, the PS will be maximum under Plan II: Debt quity Mix. Under favorable economic conditions, debt financing gives more benefit due to tax shield availability than equity or preference financing. iii. BIT PS Indifference Point : Plan I and Plan II ( BIT*)x( TC ) (BIT * Interest)x( TC ) BIT * ( 0.40) (BIT *,5,000)x( 0.40) 3,,500,56,50 IPCC_33e_Costing_Capital Structure_Assignment Solutions 36

6 o. for CA/CWA & MC/CC MASTR MIDS 3,,500 BIT* x,5,00 Rs.,50,000 3,,500,56,50 BIT PS Indifference Point: Plan I and Plan III BIT * x( TC ) BIT * ( T ) Pr ef.div. C Pr ef.div. 3,,500,5,000 BIT* x x T 3,,500,56, Rs.4,6, i. Computation of arnings per Share (PS): C Problem o. Plans P (Rs.) Q (Rs.) R (Rs.) arnings before interest & tax (BIT) 8,00,000 8,00,000 8,00,000 Less: Interest charges -,00,000 - arnings before tax (BT) 8,00,000 6,00,000 8,00,000 Less: 50% 9,00,000 8,00,000 9,00,000 arnings after tax (AT) 9,00,000 8,00,000 9,00,000 Less: Preference share dividend - -,00,000 arnings available for equity shareholders 9,00,000 8,00,000 7,00,000 o. of shares,00,000,00,000,00,000.p.s (Rs.) ii. Computation of Financial Break-even Points: Proposal P 0 Proposal Q Rs.,00,000 (Interest charges) Proposal R arnings required for payment of preference share dividend i.e. Rs.,00, (Tax Rate) Rs.4,00,000 iii. Computation of Indifference Point between the Proposals: The indifference point (BIT - I )(- T) (BIT - I )(- T) Where, BIT arnings before interest and tax I Fixed Charges (Interest) under Proposal P I Fixed charges (Interest) under Proposal Q T Tax Rate umber of quity shares in Proposal P umber of quity shares in Proposal Q Combination of Proposals: a. Indifference point where BIT of proposal P and proposal Q is equal (BIT - 0)( 0.5) (BIT -,00,000)(- 0.5),00,000,00, BIT (,00,000) (0.5 BIT -,00,000),00, BIT BIT,00,000 BIT Rs. 4,00,000 IPCC_33e_F.M_Capital Structure_Assignment Solutions 37

7 Rs.,00,000 7% Ph: /6 b. Indifference point where BIT of proposal P and Proposal R is equal: (BIT - I,00,000 )(- T) )(- T) (BIT - 0)(- 0.5) (BIT - I (BIT - 0)(- 0.5) -,00,000,00,000 - Preference share dividend 0.5BIT 0.5BIT -,00,000,00,000,00, BIT 0.5 BIT -,00,000 BIT,00, Rs. 8,00,000 c. Indifference point where BIT of proposal Q and proposal R are equal: (BIT -,00,000)(- 0.5) (BIT - 0)(- 0.5) -,00,000,00,000,00, BIT -,00, BIT,00,000 There is no indifference point between proposal Q and proposal R Analysis: It can be seen that Financial proposal Q dominates proposal R, since the financial breakeven-point of the former is only Rs.,00,000 but in case of latter, it is Rs. 4,00,000. Problem o. Amount BIT 0,00,000 Less: Interest (5,000 x 50 x 4%) 5,5,000 ASH 4,75,000 Market value of debt 5,000 x 50 Rs.37,50,000 Market value of equity ASH 4,75,000 Rs.9,8,750 K e 0. 6 Market value of firm Market value of debt + Market value of equity 37,50, ,8,750,9,68,750 Overall cost of capital (K o ) BIT 0,00, % Market value of firm,9,68,750 Problem o.3 Firms M OI/BIT Rs.0,000 Rs.0,000 Debt Ke 0%.50% Kd OI int erest Value of equity (S) cos tofequity 0,000 s n Rs.,00,000, 0% Vn Rs.,00,000 s m 0,000 7,000 Rs.,3,043.50% Vm,3,043 +,00,000 {V S + D} Rs.,3,043 IPCC_33e_Costing_Capital Structure_Assignment Solutions 38

8 Rs. 7% o. for CA/CWA & MC/CC MASTR MIDS Assume you have 0% share of levered company. i.e. M. Therefore, investment in 0% ofequity of levered company 0%,3,043 Rs.,304.3 Return will be 0% of (0,000 7,000) Rs.,300. Alternate Strategy will be: Sell your 0% share of levered firm for Rs.,304.3 and borrow 0% of levered firms debt i.e.0% of Rs.,00,000 and invest the money i.e. 0% in unlevered firms stock: Total resources /Money we have, ,000,304.3 and you invest 0% of,00,000 Rs.0,000 Surplus cash available with you is, ,000 Rs.,304.3 Your return 0% BIT of unlevered firm Interest to be paid on borrowed funds i.e. 0% of Rs.0,000 7% of Rs.0,000, Rs.,300 i.e. your return is same i.e. Rs.,300 which you are getting from company before investing in M company. But still you have Rs.,304.3 excess money available with you. Hence, you are better off by doing arbitrage. Problem o.4 Firms U L OI/BIT Rs. 0,000 Rs. 0,000 Debt,00,000 Ke 0% 8% Kd Value of equity capital (s) BIT K e Interest 0, Total value of the firm V S + D Rs.,00,000 +Rs. 7, +,00,000 Rs.,7, IPCC_33e_F.M_Capital Structure_Assignment Solutions 39 0,000 7,000 Rs.,00,000 Rs. 7, 0.8 Assume you have 0% shares of unlevered firm i.e. investment of 0% of Rs.,00,000 Rs.0,000 and 0% on Rs. 0,000. Investment will be 0% of earnings available forequity i.e. 0% 0,000 Rs.,000. Alternative strategy: Sell your shares in unlevered firm for Rs. 0,000 and buy 0% shares of levered firm s equityplus debt i.e. 0% equity of levered firm 7, 0% debt of levered firm 0,000 Total investment 7, Your resources are Rs. 0,000 Surplus cash available Surplus Investment 0,000 7, Rs.,778 Your return on investment is: 7% on debt of Rs. 0, % on equity i.e. 0% of earnings available for equity holders i.e. (0% 3,000),300 Total return,000 i.e. in both the cases the return received is Rs.,000 and still you have excess cash of Rs.,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 increasing the value of levered firm till equilibrium is reached. TH D