AFM M.

Com

AIMS IHE

M.Com ( I semester) : 2018-19

Advanced Financial Management (AFM)

Module : 01 : Financing Decision

Problems on EBIT-EPS Analysis:

Problem : 01

A Company’s capital structure consists of the following :

Equity share of ₹ 100 each ₹ 20 lakhs

Retained earnings ₹ 10 lakhs
9% preference shares ₹ 12 lakhs
7% Debentures ₹ 8 lakhs
Total ₹ 50 lakhs
The company earns 12% on its capital. The income tax rate is 50%. The company requires a sum of ₹ 25
lakh to finance its expansion programme for which the following alternatives are available to it:

(i) Issue of 20,000 equity shares at a premium of ₹ 25 per share.

(ii) Issue of 10% preference shares.
(iii) Issue of 8% debentures.
It is estimated that the P/E ratio in the cases of equity, preference and debentures financing would be
21, 4, 17 and 15.7 respectively.

Problem : 02 : 2015 : sec - B

The balance sheet of Alpha Numeric Company is given below:
Liabilities ₹ Assets ₹
Equity capital (₹ 10 per share) 90,000 Net fixed assets 2,25,000
10% Long term debt 1,20,000 Current assets 75,000
Retained earning 30,000
Current liabilities 60,000
3,00,000 3,00,000
The company’s total assets turnover ratio is 3, its fixed operating cost is ₹ 1,50,000 and its variable
operating cost ratio is 50%. The income tax rate is 50%.
You are required to:
(i) Calculate the different types of leverages for the company.
(ii) Determine the likely level of EBIT if EPS is: a) ₹ 1 b) ₹ 2 c) ₹ 0

Sangeetha S, M.Com - NET, KSET

Assistant Professor, AIMS IHE
Peenya, Bangalore
sangpmagadum18@gmail.com Page 1
AFM M.Com

Problem : 03 :
The balance sheet of DJ Company is given below:
Liabilities ₹ Assets ₹
Equity capital (₹ 10 per share) 60,000 Net fixed assets 1,50,000
10% Debentures 80,000 Current assets 50,000
Retained earning 20,000
Current liabilities 40,000
2,00,000 2,00,000
The company’s total assets turnover ratio is 3, its fixed operating cost is ₹ 1,00,000 and its variable
operating cost ratio is 40%. The income tax rate is 50%.
You are required to:
(i) Calculate the different types of leverages for the company.
(ii) Determine the likely level of EBIT if EPS is 5

Problem : 04
Vishal limited is setting up a project with a capital outlay of ₹ 60,00,000. It has two alternatives in
financing the project cost.
Alternative I : 100 % equity finance by issuing equity shares of ₹ 10 each.
Alternative II : Debt-equity ratio 2:1 (issuing equity shares of ₹ 10 each)
The rate of interest payable on the debts is 18% p.a. the corporate tax rate is 40%. Calculate the
indifference point between the two alternative methods of financing.

Problem : 05
Ganapathi Ltd. is considering three financing plans. The key information is as follows:
a) Total investment to be raised ₹ 2,00,000
b) Plans of financial proportion:

Plans Equity Debt Preference shares

A 100% - -
B 50% 50% -
C 50% - 50%
c) Cost of debt 8%
Cost of preference shares 8%
d) Tax rate 50%
e) Equity shares of the face value of ₹ 10 each will be issued at a premium of ₹ 10 per share.
f) Expected EBIT is ₹ 80,000

You are required to determine for each plan:-

(i) Earnings per share (EPS)

(ii) The financial break-even point
(iii) Indicate if any of the plans dominate band compute the EBIT range among the plans for
indifference.

Sangeetha S, M.Com - NET, KSET

Assistant Professor, AIMS IHE
Peenya, Bangalore
sangpmagadum18@gmail.com Page 2
AFM M.Com

Problem : 06 : 2018 : sec - C

Paramount Produces Ltd. wants to raise ₹ 100 lakhs for a diversification project. Current estimate of
earnings before interest and taxes (EBIT) from the new project is ₹ 22 lakhs per annum.

Cost of debt will be 15% for amounts up to and including ₹ 40 lakhs, 16% for additional amounts up to
and including ₹ 50 lakhs and 18% for additional amounts above ₹ 50 lakhs.

The equity shares (face value ₹ 10) of the company have a current market value of ₹ 40. This is expected
to fall to ₹ 32 if debts exceeding ₹ 50 lakhs are raised.

The following options are under consideration of the company :

Plans Equity Debt

I 50% 50%
II 60% 40%
III 40% 60%
Determine the earnings per share (EPS) for each option and state which option the company should
exercise. Tax rate applicable to the company is 50%.

Problem : 07

Yoyo Limited presently has ₹ 36,00,000 in debt outstanding bearing an interest rate of 10 %. It wishes to
finance a ₹ 40,00,000 expansion programme and is considering three alternatives: additional debt at
12% interest, preference shares with an 11 % dividend, and the issue of equity shares at 16% share. The
company presently has 8,00,000 shares outstanding and is in a 40% tax bracket. If earnings before
interest and taxes are presently ₹ 15,00,000, what would be earnings per share for the three
alternatives, assuming no immediate increase in profitability?

Problem : 08 :

Alpha Limited requires funds amounting to ₹ 80 lakh for its new project. To raise the funds, the company
has following two alternatives:

(i) To issue Equity shares of ₹ 100 each (at par) amounting to ₹ 60 lakh and borrow the balance
amount at the interest of 12% p.a. or
(ii) To issue equity shares of ₹ 100 each (at par) and 12 % debentures in equal proportion.

The income- tax rate is 30%.

Find out the point of indifference between the available two modes of financing and state which
option will be beneficial in different situations.

Sangeetha S, M.Com - NET, KSET

Assistant Professor, AIMS IHE
Peenya, Bangalore
sangpmagadum18@gmail.com Page 3
AFM M.Com

Problems on Capital Structure theories :

A. Net Income approach (NI)

Problem : 01

Rupa Ltd.’s EBIT is ₹ 5,00,000. The company has 10%, ₹ 20,00,000 debentures. The equity capitalization
rate i.e. Ke is 16%. You are required to calculate : (i) market value of equity and value of firm (ii) overall
cost of capital.

Problem : 02

X Ltd. is expecting an annual EBIT of ₹ 1 lakh. The company has ₹ 4 lakhs in 10% debentures. The cost of
equity capital or capitalization rate is 12.5%. you are required to calculate the total value of the firm
according to the Net Income approach.

Problem : 03

a) A company expects a net income of ₹ 80,000. It has ₹ 2,00,000, 8% Debentures. The equity
capitalization rate of the company is 10%. Calculate the value of the firm and overall
capitalization rate according to the Net Income approach (ignoring income tax)
b) If the debenture debt is increased to ₹ 3,00,000, what shall be the value of the firm and the
overall capitalization rate?

B. Traditional approach:

Problem : 04

Indra Ltd. has EBIT of ₹ 1,00,000. The company makes us debt and equity capital. The firm has 10%
debentures of 5,00,000 and the firm’s equity capitalization rate is 15%. You are required to compute: (i)
Current value of the firm (ii) Overall cost of capital.

Problem : 05

A company’s current net operating income (EBIT) is ₹ 8,00,000. The company has ₹ 20 lakhs of 10% debt
outstanding. Its equity capitalization rate is 15%. The company is considering to increase its debt by
raising additional ₹ 10 lakhs and to utilize these funds to retire the amount of equity. However , due to
increased financial risk, the cost of entire debt is likely to increase to 12% and the cost of equity is 18%.
You are required to compute the market value of the company using traditional model and also make
recommendations regarding the proposal.

C. Net Operating Income approach (NOI)

Problem : 06

Amita Ltd’s operating income is ₹ 5,00,000. The firm’s cost of debt is 10% and currently the firm employs
₹ 15,00,000 of debt. The overall cost of capital of the firm is 15%. You are required to determine: (i) total
value of the firm (ii) cost of equity.

Sangeetha S, M.Com - NET, KSET

Assistant Professor, AIMS IHE
Peenya, Bangalore
sangpmagadum18@gmail.com Page 4
AFM M.Com

Problem : 07

ABC company expects a net operating income of ₹ 1,00,000. It has ₹ 5,00,000, 6% debentures. The
overall capitalization rate is 10%. Calculate the value of the firm and the equity capitalization rate (cost
of equity) according to the net operating income approach. If the debentures debt is increased to ₹
7,50,000. What will be the effect on value of the firm and the equity capitalization rate?

Problem : 08 : 2015 : sec-B

XYZ expects a net operating income of ₹ 2,00,000. It has 8,00,000, 6% debentures. The overall
capitalization rate is 10%. Calculate the value of the firm and the equity capitalization rate (cost of
equity) according to the net operating income approach. If the debentures debt is increased to ₹
10,00,000. What will be the effect on value of the firm and the equity capitalization rate?

Problem : 09 : 2016 : sec -B

There are two firms ‘A’ and ‘B’ which are exactly identical except that A does not use any debt in its
financing, while B has ₹ 2,50,000, 6% debentures in its financing. Both the firms have earnings before
interest and tax of ₹ 75,000 and the equity capitalization rate is 10%. Assuming the corporation tax is
50%, calculate the value of the firm.

Problem : 10

Companies X and Y are identical in all respects including risk factors except for debt/equity, X having
issued 10% debentures of ₹ 18 lakhs while Y has issued only equity. Both the companies earn 20%
before interest and taxes on their total assets of ₹ 30 lakhs. Assuming a tax rate of 50% and
capitalization rate of 15% for an all-equity company, compute the value of companies X and Y using (i)
net income approach (ii) net operating income approach.

Problem : 11

Alpha Ltd. and Beta Ltd. are identical except for capital structures. Alpha Ltd. has 50 per cent debt and
50 per cent equity, whereas Beta Ltd. has 20 per cent debt and 80 per cent equity. (all percentages are
in market-value terms). The borrowing rate for both companies is 8 per cent in a no – tax world, and
capital markets are assumed to be perfect.

a) (i) if you own 2 per cent of the shares of Alpha Ltd., what is your return if the company has net
operating income of ₹ 3,60,000 and the overall capitalization rate of the company, Ko is 18 per
cent? (ii) What is the implied required rate of return on equity?
b) Beta Ltd. has the same net operating income as Alpha Ltd. (i) what is the implied required equity
return of Beta Ltd.? (ii) why does it differ from that of Alpha Ltd.?

Problem : 12

S.R Ltd. expects annual net operating income of ₹ 2,00,000. It has ₹ 5,00,000 outstanding debt, cost of
debt is 10%. If the overall capitalization rate is 12.5% What would be the total value of the firm and the
equity capitalization rate according to the Net operating income approach.

Sangeetha S, M.Com - NET, KSET

Assistant Professor, AIMS IHE
Peenya, Bangalore
sangpmagadum18@gmail.com Page 5
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What will be the effect of the following on the total value of the firm and the equity capitalization rate, if
: (i) the firm increases the amount of debt from ₹ 5,00,000 to ₹ 7,50,000 and uses the proceeds of the
debt to repurchase equity shares. (ii) the firm redeems debt of ₹ 2,50,000 by issuing fresh equity shares
of the same amount.

D. Modigliani – Miller approach (MM)

Problem : 13 : When value of levered firm is more than the value of unlevered firm

There are two company N Ltd. and M Ltd. having same earnings before interest and taxes i.e. EBIT of ₹
20,000. M Ltd is a levered company having a debt of ₹ 1,00,000 @ 7% rate of interest. The cost of equity
of N Ltd. is 10% and of M Ltd. is 11.50%. Find out how arbitrage process will be carried on?

Problem : 14 : When value of Unlevered firm is more than the value of levered firm

There are two company N Ltd. and M Ltd. having same NOI of ₹ 20,000 except that L Ltd. is a levered
company having a debt of ₹ 1,00,000 @ 7% and cost of equity of U Ltd. & L Ltd. are 10% and 18%
respectively. Show how arbitrage process will work.

Problem : 15

X company has EBIT of ₹ 1,00,000. It expects a return on its investment at a rate of 12.5%. you are
required to find out the total value of the firm according to the Miller-Modigliani theory.

Problem : 16

There are two firms X and Y which are exactly identical except that X does not use any debt in its
financing, while Y has ₹ 1,00,000 5% Debentures in its financing. Both the firms have EBIT of ₹ 25,000
and the equity capitalization rate is 10%. Assuming the corporation tax of 50% calculate the value of the
firm using M & M approach.

Problem : 17 : 2017 : Sec -B

Companies U and L are identical in every respect except that the former does not use debt in its capital
structure, while the latter employs ₹ 6,00,000 10% debt. Assuming that (i) all the M-M assumptions are
met, (ii) the corporate tax rate is 35% (iii) the EBIT is ₹ 1,20,000, and (iv) the equity capitalization of the
unleveled company is 0.20. what will be the value of the firms U and L?

Problem : 18

Firms X and Y are identical in every respect except that Y is levered while X is unlevered. Company Y has
₹ 20,00,000 8% debentures outstanding.. Assuming that (i) all the M-M assumptions are met, (ii) the
corporate tax rate is 50% (iii) the EBIT is ₹ 6,00,000, and (iv) the equity capitalization rate for company Y
is 10%. what will be the value of the firms according to MM approach?

Sangeetha S, M.Com - NET, KSET

Assistant Professor, AIMS IHE
Peenya, Bangalore
sangpmagadum18@gmail.com Page 6
AFM M.Com

Problem : 19

The following is the data regarding two companies ‘A’ and ‘B’ belonging to the same equivalent risk
class:

Company A Company B
Number of ordinary shares 1,00,000 1,50,000
8% Debentures 50,000 -
Market price per share ₹ 1.30 ₹ 1.00
Profit before interest ₹ 20,000 ₹ 20,000
All profits after paying debenture interest are distributed as dividends. You are required to explain how
under Modigliani and Miller approach, an investor holding 10% of shares in company ‘A’ will be better
off in switching his holding to company ‘B’.

Problem : 20 : 2018 Sec- C

The following is the data regarding two companies ‘X’ and ‘Y’ belonging to the same equivalent risk
class:

Company A Company B
Number of ordinary shares 90,000 1,50,000
6% Debentures 60,000 -
Market price per share ₹ 1.20 ₹ 1.00
Profit before interest ₹ 18,000 ₹ 18,000
All profits after paying debenture interest are distributed as dividends. You are required to explain how
under Modigliani and Miller approach, an investor holding 10% of shares in company ‘X’ will be better
off in switching his holding to company ‘Y’.

Sangeetha S, M.Com - NET, KSET

Assistant Professor, AIMS IHE
Peenya, Bangalore
sangpmagadum18@gmail.com Page 7