CHAPTER 4

FINANCING DECISIONS
UNIT I : COST OF CAPITAL
Question 1
What do you understand by Weighted Average Cost of Capital? (PCC-Nov. 2009)(3 marks)
Answer
Weighted Average Cost of Capital
The composite or overall cost of capital of a firm is the weighted average of the costs of
various sources of funds. Weights are taken in proportion of each source of funds in capital
structure while making financial decisions. The weighted average cost of capital is calculated
by calculating the cost of specific source of fund and multiplying the cost of each source by its
proportion in capital structure. Thus, weighted average cost of capital is the weighted average
after tax costs of the individual components of firms capital structure. That is, the after tax
cost of each debt and equity is calculated separately and added together to a single overall
cost of capital.
Question 2
Z Ltd.s operating income (before interest and tax) is Rs. 9,00,000. The firms cost of debt is
10 per cent and currently firm employs Rs. 30,00,000 of debt. The overall cost of capital of
firm is 12 per cent.
Required:
Calculate cost of equity. (PCC-Nov. 2007)(3 marks)
Answer
Calculation of Cost of Equity
Calculation of value of firm (v) =
( )
o
K capital of cost Overall
EBIT
00 Rs.75,00,0
0.12
9,00,000
= =
Market value of equity (S) = V Debts
4.2
= 75,00,000 30,00,000 = Rs. 45,00,000
Market value of debts (D) = 30,00,000
|
.
|

\
|
|
.
|

\
|
=
S
D
K
S
V
K equity) of (Cost K
d o e
|
.
|

\
|
|
.
|

\
|
=
45,00,000
30,00,000
0.10
45,00,000
75,00,000
0.12
= 0.20 .067 = .133 100
Ke = 13.3%.
Question 3
ABC Ltd. wishes to raise additional finance of Rs. 20 lakhs for meeting its investment plans.
The company has Rs.4,00,000 in the form of retained earnings available for investment
purposes. The following are the further details:
+ Debt equity ratio 25 : 75.
+ Cost of debt at the rate of 10 percent (before tax) upto Rs. 2,00,000 and 13%
(before tax) beyond that.
+ Earning per share, Rs. 12.
+ Dividend payout 50% of earnings.
+ Expected growth rate in dividend 10%.
+ Current market price per share, Rs.60.
+ Companys tax rate is 30% and shareholders personal tax rate is 20%.
Required:
(i) Calculate the post tax average cost of additional debt.
(ii) Calculate the cost of retained earnings and cost of equity.
(iii) Calculate the overall weighted average (after tax) cost of additional finance.
(PCC-May 2008)(8 marks)
Answer
Pattern of raising capital = 0.25 20,00,000
Debt = 5,00,000
Equity = 15,00,000
Equity fund (Rs. 15,00,000)
4.3
Retained earning = Rs. 4,00,000
Equity (additional) = Rs. 11,00,000
Total = Rs. 15,00,000
Debt fund (Rs. 5,00,000)
10% debt = Rs. 2,00,000
13% debt = Rs. 3,00,000
Total = Rs. 5,00,000
(i) Kd = Total Interest (1 t) / Rs. 5,00,000
= [20,000 + 39,000] (1 0.3)/ 5,00,000 or (41,300 / 5,00,000) 100 = 8.26%
(ii) Ke = EPS payout / mp + g = 12 (50%) / 60 100 + 10%
10% + 10% = 20%
Kr = Ke (1 tp) = 20(1 0.2) = 16%
(iii) Weighted average cost of capital
Amount After tax Cost
Equity Capital 11,00,000 20.00% 2,20,000
Retained earning 4,00,000 16.00% 64,000
Debt 5,00,000 8.26% 41,300
Total 20,00,000 3,25,300
Ko = (3,25,300 / 20,00,000) 100 = 16.27%
Question 4
The capital structure of MNP Ltd. is as under:
9% Debenture Rs. 2,75,000
11% Preference shares Rs. 2,25,000
Equity shares (face value : Rs. 10 per share) Rs. 5,00,000
Rs. 10,00,000
Additional information:
(i) Rs. 100 per debenture redeemable at par has 2% floatation cost and 10 years of maturity.
The market price per debenture is Rs. 105.
(ii) Rs. 100 per preference share redeemable at par has 3% floatation cost and 10 years of
maturity. The market price per preference share is Rs. 106.
4.4
(iii) Equity share has Rs. 4 floatation cost and market price per share of Rs. 24. The next year
expected dividend is Rs. 2 per share with annual growth of 5%. The firm has a practice of
paying all earnings in the form of dividends.
(iv) Corporate Income-tax rate is 35%.
Required :
Calculate Weighted Average Cost of Capital (WACC) using market value weights.
(PCC-June 2009)(9 marks)
Answer
Computation of Weighted Average Cost of Capital using Market Value Weights
Cost of Equity (ke)
Ke =
Po
D
1
+ g
=
4 . Rs 24 . Rs
2 . Rs

+ 5%
= 15%
Cost of Debt (kd)
Kd =
2 / ) NP RV (
N / ) NP RV ( ) T 1 ( I
+
+
=
2 / ) 98 100 (
10 / ) 98 100 ( ) 35 . 0 1 ( 9
+
+
=
99
20 . 0 85 . 5 +
= 6.11%
Cost of Preference Shares (kp)
Kp =
2 / ) NP RV (
N / ) NP RV ( PD
+
+
=
2 / ) 97 100 (
10 / ) 97 100 ( 11
+
+
=
5 . 98
30 . 11
= 11.47%
4.5
Calculation of WACC using Market Value Weights
Source of Capital Market
Value (Rs.)
Weights to
Total Capital
Specific
Cost
Total Cost
Debentures (Rs. 105 per
debenture)
2,88,750 0.1672 0.0611 0.0102
Preference Shares (Rs. 106 per
preference share)
2,38,500 0.1381 0.1147 0.0158
Equity Shares (Rs. 24 per share) 12,00,000 0.6947 0.1500 0.1042
17,27,250 1.00 0.1302
WACC using market value weights = 13.02%
Question 5
Y Ltd. retains Rs. 7,50,000 out of its current earnings. The expected rate of return to the
shareholders, if they had invested the funds elsewhere is 10%. The brokerage is 3% and the
shareholders come in 30% tax bracket. Calculate the cost of retained earnings.
(PCC-Nov. 2009)(2 marks)
Answer
Computation of Cost of Retained Earnings (Kr)
Kr = k (1-TP) (1-B)
Kr = 0.10 (1- 0.30) (1- 0.03)
= 0.10 (0.70) (0.97)
= 0.0679 or 6.79%
Cost of Retained Earnings = 6.79%
4.6
UNIT II : CAPITAL STRUCTURE DECISIONS
Question 1
Explain in brief the assumptions of Modigliani-Miller theory. (PCC-May 2007)(2 marks)
Answer
Assumptions of Modigliani Miller Theory
(a) Capital markets are perfect. All information is freely available and there is no transaction
cost.
(b) All investors are rational.
(c) No existence of corporate taxes.
(d) Firms can be grouped into Equivalent risk classes on the basis of their business risk.
Question 2
What is optimum capital structure? Explain. (PCC-Nov. 2007& 2008)(2 marks)
Answer
Optimum Capital Structure: Optimum capital structure deals with the issue of right mix of
debt and equity in the long-term capital structure of a firm. According to this, if a company
takes on debt, the value of the firm increases upto a certain point. Beyond that value of the
firm will start to decrease. If the company is unable to pay the debt within the specified period
then it will affect the goodwill of the company in the market. Therefore, company should select
its appropriate capital structure with due consideration of all factors.
Question 3
Explain the assumptions of Net Operating Income approach (NOI) theory of capital structure.
(PCC-Nov. 2007)(3 marks)
Answer
Assumptions of Net Operating Income (NOI) Theory of Capital Structure
According to NOI approach, there is no relationship between the cost of capital and value of
the firm i.e. the value of the firm is independent of the capital structure of the firm.
Assumptions
(a) The corporate income taxes do not exist.
(b) The market capitalizes the value of the firm as whole. Thus the split between debt and
equity is not important.
(c) The increase in proportion of debt in capital structure leads to change in risk perception of
the shareholders.
4.7
(d) The overall cost of capital (Ko) remains constant for all degrees of debt equity mix.
Question 4
Explain the principles of Trading on equity. (PCC-May 2008)(2 marks)
Answer
The term trading on equity means debts are contracted and loans are raised mainly on the
basis of equity capital. Those who provide debt have a limited share in the firms earning and
hence want to be protected in terms of earnings and values represented by equity capital.
Since fixed charges do not vary with firms earning before interest and tax, a magnified effect is
produced on earning per share. Whether the leverage is favourable, i n the sense, increase in
earning per share more proportionately to the increased earning before interest and tax,
depends on the profitability of investment proposal. If the rate of returns on investment
exceeds their explicit cost, financial leverage is said to be positive.
Question 5
Discuss the concept of Debt-Equity or EBIT-EPS indifference point, while determining the
capital structure of a company. (PCC-June 2009)(2 marks)
Answer
Concept of Debt-Equity or EBIT-EPS Indifference Point while Determining the Capital
Structure of a Company
The determination of optimum level of debt in the capital structure of a company is a
formidable task and is a major policy decision. It ensures that the firm is able to service its
debt as well as contain its interest cost. Determination of optimum level of debt involves
equalizing between return and risk.
EBIT EPS analysis is a widely used tool to determine level of debt in a firm. Through this
analysis, a comparison can be drawn for various methods of financing by obtaining
indifference point. It is a point to the EBIT level at which EPS remains unchanged irrespective
of debt-equity mix. The indifference point for the capital mix (equity share capital and debt)
can be determined as follows:
1
1
E
) T 1 ( ) I EBIT (
=
2
2
E
) T 1 )( I EBIT (
Question 6
There are two firms P and Q which are identical except P does not use any debt in its capital
structure while Q has Rs. 8,00,000, 9% debentures in its capital structure. Both the firms have
earning before interest and tax of Rs. 2,60,000 p.a. and the capitalization rate is 10%.
Assuming the corporate tax of 30%, calculate the value of these firms according to MM
Hypothesis. (PCC-Nov. 2009)(3 marks)
4.8
Answer
Calculation of Value of Firms P and Q according to MM Hypothesis
Market Value of Firm P (Unlevered)
e
u
K
) t - (1 EBIT
V =
% 10
) 0.30 - (1 2,60,000
=
18,20,000 Rs.
% 10
1,82,000 Rs.
= =
Market Value of Firm Q (Levered)
VE = Vu + DT
= Rs.18,20,000 + (8,00,000 0.30)
= Rs.18,20,000 + 2,40,000 = Rs. 20,60,000
4.9
UNIT III : BUSINESS RISK AND FINANCIAL RISK
Question 1
Differentiate between Business risk and Financial risk. (PCC-May 2007 & Nov. 2009)(3 marks)
Answer
Business Risk and Financial Risk
Business risk refers to the risk associated with the firms operations. It is an unavoidable risk
because of the environment in which the firm has to operate and the business risk is represented
by the variability of earnings before interest and tax (EBIT). The variability in turn is influenced by
revenues and expenses. Revenues and expenses are affected by demand of firms products,
variations in prices and proportion of fixed cost in total cost.
Whereas, Financial risk refers to the additional risk placed on firms shareholders as a result
of debt use in financing. Companies that issue more debt instruments would have higher
financial risk than companies financed mostly by equity. Financial risk can be measured by
ratios such as firms financial leverage multiplier, total debt to assets ratio etc.
Question 2
Explain the concept of leveraged lease. (PCC-Nov. 2007)(2 marks)
Answer
Concept of Leveraged Lease: Leveraged lease involves lessor, lessee and financier. In
leveraged lease, the lessor makes a substantial borrowing, even upto 80 per cent of the
assets purchase price. He provides remaining amount about 20 per cent or so as equity to
become the owner. The lessor claims all tax benefits related to the ownership of the assets.
Lenders, generally large financial institutions, provide loans on a non-recourse basis to the
lessor. Their debt is served exclusively out of the lease proceeds. To secure the loan provided
by the lenders, the lessor also agrees to give them a mortgage on the asset. Leveraged lease
are called so because the high non-recourse debt creates a high degree of leverage.
Question 3
The following details of RST Limited for the year ended 31March, 2006 are given below:
Operating leverage 1.4
Combined leverage 2.8
Fixed Cost (Excluding interest) Rs. 2.04 lakhs
Sales Rs. 30.00 lakhs
12% Debentures of Rs. 100 each Rs. 21.25 lakhs
4.10
Equity Share Capital of Rs. 10 each Rs. 17.00 lakhs
Income tax rate 30 per cent
Required:
(i) Calculate Financial leverage
(ii) Calculate P/V ratio and Earning per Share (EPS)
(iii) If the company belongs to an industry, whose assets turnover is 1.5, does it have a
high or low assets leverage?
(iv) At what level of sales the Earning before Tax (EBT) of the company will be equal to
zero? (PCC-May 2007)(8 marks)
Answer
(i) Financial leverage
Combined Leverage = Operating Leverage (OL) Financial Leverage (FL)
2.8 = 1.4 FL
FL = 2
Financial Leverage = 2
(ii) P/V Ratio and EPS
P/V ratio = 100
S
C

Operating leverage = 100

2,04,000 C
C
1.4

=
1.4 (C 2,04,000) = C
1.4 C 2,85,600 = C
0.4
2,85,600
C =
C = 7,14,000
P/V = 23.8% 100
30,00,000
7,14,000
=
Therefore, P/V Ratio = 23.8%
4.11
EPS =
shares equity of No.
tax after Profit
EBT = Sales V FC Interest
= 30,00,000 22,86,000 2,04,000 2,55,000
= 2,55,000
PAT = EBT Tax
= 2,55,000 76,500 = 1,78,500
EPS 1.05
1,70,000
1,78,500
= =
(iii) Assets turnover
Assets turnover = .784 0
38,25,000
30,00,000
Assets Total
Sales
= =
0.784 < 1.5 means lower than industry turnover.
(iv) EBT zero means 100% reduction in EBT. Since combined leverage is 2.8, sales have to
be dropped by 100/2.8 = 35.71%. Hence new sales will be
30,00,000 (100 35.71) = 19,28,700.
Therefore, at 19,28,700 level of sales, the Earnings before Tax of the company will be
equal to zero.
Question 4
A firm has Sales of Rs. 40 lakhs; Variable cost of Rs. 25 lakhs; Fixed cost of Rs. 6 lakhs; 10%
debt of Rs. 30 lakhs; and Equity Capital of Rs. 45 lakhs.
Required:
Calculate operating and financial leverage. (PCC-Nov. 2007)(2 marks)
Answer
Calculation of Operating and Financial Leverage
Rs.
Sales 40,00,000
Less: Variable cost 25,00,000
Contribution (C) 15,00,000
Less: Fixed cost 6,00,000
EBIT 9,00,000
4.12
Less: Interest 3,00,000
EBT 6,00,000
Operating leverage = 1.67
9,00,000
15,00,000
EBIT
C
= =
Financial leverage = 1.50
6,00,000
9,00,000
EBT
EBIT
= =
Question 5
The following data relate to RT Ltd:
Rs.
Earning before interest and tax (EBIT) 10,00,000
Fixed cost 20,00,000
Earning Before Tax (EBT) 8,00,000
Required: Calculate combined leverage. (PCC-May 2008)(2 marks)
Answer
Contribution:
C = S V and
EBIT = C F
10,00,000 = C 20,00,000
C = 30,00,000
Operating leverage = C / EBIT = 30,00,000/10,00,000 = 3 times
Financial leverage = EBIT/EBT = 10,00,000/8,00,000 = 1.25 times
Combined leverage = OL x FL = 3 x 1.25 = 3.75 times
Question 6
A company operates at a production level of 1,000 units. The contribution is Rs. 60 per unit,
operating leverage is 6, and combined leverage is 24. If tax rate is 30%, what would be its
earnings after tax? (PCC-Nov. 2008)(3 marks)
Answer
Computation of Earnings after tax
Contribution = Rs. 60 1,000 = Rs. 60,000
Operating Leverage (OL) Financial Leverage (FL) = Combined Leverage (CL)
4.13
6 Financial Leverage = 24
Financial Leverage = 4
6
EBIT
60,000
EBIT
on Contributi
Leverage Operating = = =
10,000
6
60,000
EBIT = =
4
EBT
EBIT
FL = =
2,500
4
10,000
4
EBIT
EBT = = =
Since tax rate = 30%
Earnings after Tax (EAT) = EBT (1 0.30)
= 2,500 (0.70)
Earning After Tax (EAT) = 1,750
Question 7
From the following financial data of Company A and Company B: Prepare their Income
Statements.
Company A Company B
Rs. Rs.
Variable Cost 56,000 60% of sales
Fixed Cost 20,000 -
Interest Expenses 12,000 9,000
Financial Leverage 5 : 1 -
Operating Leverage - 4 : 1
Income Tax Rate 30% 30%
Sales - 1,05,000
(PCC-Nov. 2009)(8 marks)
Answer
Income Statements of Company A and Company B
Company A Company B
Rs. Rs.
4.14
Sales 91,000 1,05,000
Less: Variable cost 56,000 63,000
Contribution 35,000 42,000
Less: Fixed Cost 20,000 31,500
Earnings before interest and tax (EBIT) 15,000 10,500
Less: Interest 12,000 9,000
Earnings before tax (EBT) 3,000 1,500
Less: Tax @ 30% 900 450
Earnings after tax (EAT) 2,100 1,050
Working Notes:
Company A
(i) Financial Leverage =
Interest EBIT
EBIT

5 =
12,000 EBIT
EBIT

5 (EBIT 12,000) = EBIT