Theories of Capital Structure

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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...
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