Theories of Capital Structure
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 | Debt | Equity | After tax cost of debt | Ke(%) | 1 | 400000 | 100000 | 9 | 10 | 2 | 250000 | 250000 | 6 | 11 | 3 | 100000 | 400000 | 5 | 14 |
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) % | Ke(%) | Nil | Nil | 12 | 100000 | 10 | 12 | 200000 | 10.5 | 12.6 | 300000 | 11 | 13 | 400000 | 12 | 13.6 | 500000 | 14 | 15.6 | 600000 | 17 | 20 |
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
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 | Debt | Equity | After tax cost of debt | Ke(%) | 1 | 400000 | 100000 | 9 | 10 | 2 | 250000 | 250000 | 6 | 11 | 3 | 100000 | 400000 | 5 | 14 |
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) % | Ke(%) | Nil | Nil | 12 | 100000 | 10 | 12 | 200000 | 10.5 | 12.6 | 300000 | 11 | 13 | 400000 | 12 | 13.6 | 500000 | 14 | 15.6 | 600000 | 17 | 20 |
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