CAPITAL THEORY – QUESTION BANK / ASSIGNMENT

Section A:
1. Explain the different approaches to valuation of a company.
2. a. How is the value of a firm ascertained through Net Income and Net
Operating Income Approaches? Illustrate with examples.
b. What are the variations in the assumptions for both these approaches?
3. Define EPS. How does it help a company to raise its credibility in the capital
market?
4. List out and explain the various ways in which cost of equity capital can be estimated.
Why is the cost of retained earnings less than equity capital?
5. What is Weighted Average Cost of Capital? How is it computed?
6. How will you determine the cost of debt?
7. Define cost of capital and explain its significance in financial decision making.
8. What is the optimal capital structure? How is it determined?
9. Why MM theory is called as theory of irrelevance in capital structure decisions?
10. State and explain the internal and external factors that determine the capital structure
of a firm.
11. State the qualities which a sound capital structure should possess.
12. Define operating leverage and Financial Leverages. How do they affect EBIT and
EPS?
13. What do you understand by “indifference point”? How is this employed in the context
of deciding the capital structure?
14. Explain the following:
a. Interest as Tax shield
b. Financial structure and capital structure
c. Capitalisation and capital structure
d. EBIT-EPS Analysis
e. ROI-ROE Analysis
f. Trading on Equity
g. Over capitalization and Under capitalization

SECTION B:

1. The Servex Company has the following capital structure on 30th June, 2004:
Ordinary Shares (2,00,000 shares) Rs. 40,00,000
10% Preference Shares 10,00,000
14% Debentures 30,00,000
The share of the company sells for Rs. 20. It is expected that company will pay next
year a dividend of Rs. 2 per share which will grow at 7 percent for ever. Assume a 50
percent tax rate.
(a) Compute the weighted average cost of capital based on existing capital
structure.
 (b) Compute the new weighted average cost of capital if the company raises an
additional Rs. 20,00,000 debt by issuing 15 percent debenture. This would
result in increasing the expected dividend to Rs. 3 and leave the growth rate
unchanged, but the price of share will fall to Rs. 15 per share.
© Compute the cost of capital if in (b) above, growth rate increases to 10
percent.

2. X Co. Ltd. is expecting an annual EBIT of Rs. 1 lakh. The company has Rs. 6.00
lakhs of equity and Rs. 4.00 lakhs in 10% debentures. The cost of equity capital or
capitalisation rate is 12.5%. You are required to calculate the total value of the firm.
Also find out the overall cost of capital.

3. The current market price of an equity share of a company is Rs. 90. The
current dividend per share is Rs. 4.50. In case the dividends are expected to
grow at the rate of 7% and 12%, calculate the cost of equity capital.

4. From the following capital structure of a company, calculate the overall cost of
capital, using (a) book value weights and (b) market value weights:
Source Book Value(Rs.) Market Value(Rs.)
Equity share capital (Rs. 10 shares) 45,000 40,000
Retained Earnings 15,000
Preference Share capital 10,000 10,000
Debentures 30,000 30,000

The after-tax cost of different sources of finance is as follows:

Equity share capital: 14%; Retained Earnings: 13%
Preference share capital: 10% Debentures: 5%

5. Good shape company has currently an ordinary share capital of Rs. 25,00,000
consisting of 25,000 shares of Rs. 100 each. The management is planning to raise
another Rs. 20 lakhs to finance a major programme of expansion through one of four
possible financing plans. The options are:
a. Entirely through ordinary shares.
b. Rs. 10 lakhs through ordinary shares and Rs. 10 lakhs through long term
borrowings at 8% interest p.a.
c. Rs. 5 lakhs through ordinary shares and Rs. 15 lakhs through long term
borrowings at 9% p.a.
d. Rs. 10 lakhs through ordinary shares and Rs. 10 lakhs through preference
shares with 5% dividend.
The company’s expected earnings before interest and tax (EBIT) will be Rs. 8
Lakhs. Assuming a corporate tax rate of 50%, determine the earnings per share
(EPS) for each alternative and comment on the implications of financial
leverage.

6. ABC Ltd. Has assets of Rs. 1,60,000 which has been financed with Debt of Rs.
52,000, Equity capital of Rs. 90,000 and General Reserve of Rs. 18,000.
 The company’s Profits after Interest and Taxes for the year 20XX were Rs. 13,500.
It pays interest on borrowed funds at 8% and is in the 50% tax bracket.
It has 900 equity shares of Rs. 100 each, selling at a market price of Rs. 120 per
share.
Calculate the Weighted Average Cost of Capital with Market Value weights.

7. In considering the most desirable capital structure of the company, the following
estimates of the After-tax cost of debt and equity capital has been made at various
levels of debt-equity mix:
Debt as % of Cost of Debt Cost of Equity
Capital Employed % %
0 5.0 12.0
10 5.0 12.0
20 5.0 12.5
30 5.5 13.0
40 6.0 14.0
50 6.5 16.0
60 7.0 20.0
Determine the optimal debt-equity mix for the company by calculating Composite
Cost of Capital.

8. ALPHA Ltd. has the following capital structure:

Rs.
Equity Share Capital (2,00,000 Shares) 40,00,000
6% Preference Capital 10,00,000
8% Debentures 30,00,000
The market price of the company’s equity shares is Rs. 20.
It is expected that the company will pay a current dividend of Rs. 2 per
share, which will grow at 7% for ever.
The tax rate is 50%.
Compute the following:
a. WACC based on existing capital structure.
b. The new WACC if the company raises an additional Rs. 20,00,000 debt by issuing
10% debentures, which will result in increasing the expected dividend per share to
Rs. 3 and leave the growth rate unchanged, but the price of the equity share will fall
to Rs. 15 per share.
c. The Cost of equity capital, if in (b) above, the growth rate increases to 10%.

9. B Ltd. has Equity share capital of Rs. 5,00,000 with Rs. 100 face value per share.
To meet the expenditure of an expansion programme, the company wishes to raise
Rs. 3,00,000.
The following four different alternatives are being considered to raise the required
funds:
Plan A: To raise full money from the issue of equity shares.
Plan B: To raise Rs. 1,00,000 as equity capital and Rs. 2,00,000 from
borrowings from financial institutions @ 10% interest p.a.
 Plan C: Raise fully amount from borrowings at 11% interest p.a.
Plan D: Raise Rs. 1,00,000 as equity capital and Rs. 2,00,000 from 8%
Preference shares.
You are required to suggest the most suitable plan.

10 A Ltd. is considering two alternative proposals to finance its expansion plan costing
Rs. 4,00,000.
The two proposals are:
a. Issue of loans of Rs. 2,00,000 @ 15% interest p.a.
b. Issue of 4,000 equity shares of Rs. 100 each.
The company’s tax rate is 50%.
Assuming that the EBIT in the next year will be either Rs. 70,000 or Rs. 80,000,
i) Which alternative is better?
ii) What will be the Indifference Level of EBIT under the two financial
plans?

11. A company has Sales of Rs. 10,00,000

Variable cost of Rs. 7,00,000,
Fixed Cost of Rs. 2,00,000 and
Debt of Rs. 5,00,000 @ 10% interest p.a.

a) What are the Operating Leverage, Financial Leverage and Combined leverage?
b) If the firm wants to double its EBIT, how much of a rise in sales would be needed on
a percentage basis?

(AMS – 020310)