Exercise on Unit 2 – Theories of Capital Structure
1. Companies U & L are identical in all respect except that U is unlevered while L is levered. Company L has Rs. 20 Lacs of 8% debentures outstanding. Assume a. All MM assumptions are met
b. Tax rate is 35%
c. EBIT is Rs. 6 Lacs
d. Equity capitalization rate of company U is 10%
Find the following:
a. Value of each firm according to MM approach
b. Suppose Value of U is Rs. 25 Lacs and Value of L Rs. 35 Lacs. According to MM approach, do they represent equilibrium values? If not explain the process by which equilibrium will be restored.
2. A company wishes to determine its optimum capital structure. From the following information determine the optimum capital structure of the company. Situation
| After tax cost of debt
3. Given EBIT of Rs. 200000, corporate tax rate of 35% and following data determine the amount of debt that should be used by the firm in its capital structure to maximise the value of the firm: Debt
| Kd(before Tax) %
4. Company X and Y are in the same risk class and are identical in every respect except that company X uses debt while company Y does not. The levered firm has Rs. 9,00,000 10% debentures. Both the firms earn 20% operating profit on their total assets of Rs. 15 Lacs. Assume perfect capital market, rational investors, tax rate of 35% and capitalization rate of 15% for an all equity company. a. Compute value of firm X and Y using Net Income Approach
b. Compute value of firm X and Y using Net operating Income Approach c. Using NOI approach, calculate the overall cost of capital of firm X and Y d. Which one has an optimum capital structure according to NOI...
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