CA – IPC TEST
COST OF CAPITAL & CAPITAL STRUCTURE
DURATION: 1hour 30mins
MM: 50 Marks
Solution 1:
Particulars
(`) in million
Net operating income
40
Less: Interest on debt capital (`90 million x 8%)
(7.2)
Earnings available to equity shareholders
32.8
Equity capitalization rate
16%
Market value of equity
205
Market value of debt
90
Total value of the firm
295
Ko = `40 million/`295 million = 13.56%.
Solution 2: Calculation of Cost of Preference Shares (Kp)
Cost of Redeemable Preference Shares
= Preference Dividend + (Redemption Value - Net Proceeds) /No. of Years
Redemption Value + Net Proceeds
2
Preference Dividend (PD)
= 40,000 Shares x `100 x 12% = `4,80,000
Floatation Cost
= 40,000 x `2 = 80,000
Net Proceeds (NP)
= `42,00,000 – `80,000 = 41,20,000
Redemption Value (RV)
= 40,000 Shares x `110 = 44,00,000
Kp
= `4,80,000 + (`44,00,000 - `41,20,000) /10
`44,00,000 + `41,20,000
2
= `4,80,000 + (`2,80,000) /10
`85,20,000 /2
= `4,80,000 + `28,000 = `5,08,000 = 0.1192
`42,60,000
`42,60,000
Kp
= 11.92%
(Note: Kp may be computed alternatively by taking the RV and NP for one unit of preference shares. Final figure would remain
unchanged.)
Kp
= `12 + (`110 - `103) /10
`110 + `103
2
= `12.7 = 0.1192
`106.5
= 11.92%
Solution 3: (i) Calculation of Value of Firm (VF) under Traditional approach:
Value of Firm = Value of Debt + Value of Equity
Particulars
Amount in (`)
EBIT
4,00,000
Less: Interest (`10,00,000 x 10%)
(1,00,000)
Earnings Available for Equity (EAE)
3,00,000
Equity Capitalisation Rate (Ke)
15%
Value of Equity (EAE/Ke)
20,00,000
Add: Value of Debt
10,00,000
Value of Firm
30,00,000
(ii) Calculation overall capitalisation rate and leverage ratios
Overall Capital Rate (Ko) =
EBIT
x 100
Value of Firm
= `4,00,000 x 100 = 13.33%
`30,00,000
Leverage Ratios
(a) Debt – Equity Ratio = Debt = `10,00,000 = 0.5:1
Equity
`20,00,000
(b) Debt to Total Funds =
Debt
= `10,00,000 = 0.33:1
Debt + Equity
`30,00,000
Solution 4: (i) Determination of EPS at EBIT level of `22,00,000
Financing Plan
(a)
(b)
(c)
Equity Shares (`) Debentures (`) Pref. Shares (`)
EBIT
22,00,000
22,00,000
22,00,000
Less: Interest
(16,000)
(1,21,000)
(16,000)
Taxable Income
21,84,000
20,79,000
21,84,000
Less: Tax @ 30%
(6,55,200)
(6,23,700)
(6,55,200)
EAT
15,28,800
14,55,300
15,28,800
Less: Dividend on Pref. Shares
(20,000)
(20,000)
(1,18,000)
Earnings available for equity shares
15,08,800
14,35,300
14,10,800
Number of Equity Shares
90,000
80,000
80,000
EPS (`)
16.76
17.94
17.64
(ii) Equivalency level of Earnings between Equity & Debt
[(X – `16,000) (1 - 0.30)] – `20,000 = (X – `16,000 – `1,05,000) (1 - 0.30) – `20,000
90,000
80,000
0.7X – `11,200 – `20,000 = 0.7X – `11,200 – `73,500 - `20,000
90,000
80,000
0.7X – `31,200 = 0.7X – `1,04,700
90,000
80,000
8(0.7X – `31,200) = 9(0.7X – `1,04,700)
5.6X – `2,49,600 = 6.3X – `9,42,300
5.6X – 6.3X = - `9,42,300 + `2,49,600
- 0.7X = - `6,92,700
X = `6,92,700 = `9,89,571
0.7
(iii) Equivalency level between Preferred Stock and Common Stock
(X – `16,000) (1 - 0.30) – `20,000 – `98,000 = (X – `16,000) (1 – 0.30) – `20,000
80,000
90,000
0.7X – `11,200 – `1,18,000 = 0.7X – `11,200 – `20,000
80,000
90,000
9(0.7X – `1,29,200) = 8(0.7X – `31,200)
6.3X – `11,62,800 = 5.6X – `2,49,600
6.3X – 5.6X = - `2,49,600 + `11,62,800
0.7X = `9,13,200
X = `9,13,200 = `13,04,571
0.7
Solution 5: Ascertainment of probable price of shares of Akash limited
Plan-I
Plan-II
Particulars
If `4,00,000 is
If `4,00,000 is raised by
raised as debt (`)
issuing equity shares (`)
Earnings Before Interest and Tax (EBIT)
3,60,000
3,60,000
(WN 1)
Less: Interest on old debentures
(40,000)
(40,000)
(10% of `4,00,000)
Less: Interest on new debentures
(48,000)
-(12% of `4,00,000)
Earnings Before Tax (EBT)
2,72,000
3,20,000
Less: Tax @ 50%
(1,36,000)
1,60,000
Earnings Available to equity shareholders (EAE)
1,36,000
1,60,000
No. of Equity Shares (WN 2)
30,000
40,000
Earnings per Share (EPS)
`4.53
`4.00
Price/ Earnings (P/E) Ratio
8 (WN 3)
10
Probable Price Per Share (PE Ratio × EPS)
`36.24
`40
Particulars
Working Notes:
1. Calculation of New Earnings Before Interest and Tax (EBIT):
Equity Share Capital (30,000 shares x `10)
= `3,00,000
10% Debentures `40,000 x 100
= `4,00,000
10
Reserves and Surplus
= `7,00,000
Total Capital Employed
= `14,00,000
Earnings before interest and tax (EBIT) (given)
= `2,80,000
ROCE = `2,80,000 x 100
= 20%
`14,00,000
Existing Capital
= `14,00,000
Additional funds
= `4,00,000
Total Capital Employed
= `18,00,000
EBIT = Total Capital Employed x ROCE
`18,00,000 x 20% = `3,60,000
2. Number of Equity Shares to be issued in Plan-II:
= `4,00,000 = 10,000shares
`40
Thus, after the issue total number of shares = 30,000+ 10,000 = 40,000 shares
3. Debt/Equity Ratio if `4,00,000 is raised as debt:
= `8,00,000 x 100 = 44.44%
`18,00,000
As the debt equity ratio is more than 40% the P/E ratio will be brought down to 8 in Plan-I.
Solution 6: Statement showing Calculation of Degree for various Leverages
Particulars
Present Situation (`) Debt Plan (`) Equity Plan (`)
Sales
6,00,000
8,00,000
8,00,000
Less: Variable Costs (75% of sales)
(4,50,000)
(6,00,000)
(6,00,000)
Contribution
1,50,000
2,00,000
2,00,000
Less: Fixed Costs (1/6 x 5,40,000)
(90,000)
(90,000
(90,000)
Earnings before Interest & Tax
60,000
1,10,000
1,10,000
Less: Interest
(44,000)
(74,600)
(44,000)
Earnings before Tax (EBT)
16,000
35,400
66,000
Less: Tax @ 40%
(6400)
(14,160
(26,400)
Earnings after Tax (EAT )
9,600
21,240
39,600
Less: Pref. Dividend
(4,000)
(4,000)
(4,000)
Earnings Available for Equity Shareholders (EAE)
5,600
17,240
35,600
No. of Equity Shares
500
500
2.000
(a) Earnings per share (EPS) [EAE/No. of Equity Shares] 11.20
34.48
17.80
Percentage Change in EPS
207.86%
58.93%
Price Earning Ratio (P/E Ratio)
10
4
10
(b) Market Price [EPS x P/E Ratio]
112
137.92
178
(c) Recommendation: The equity financing should be employed since the market price of an equity share is higher than that
under debt financing.
(d) Calculation of indifference point between the proposed plans
(x – 74,600) (1 – 0.4) – 4,000 = (x – 44,000) (1 – 0.4) – 4,000
500
2,000
0.6 X – 48,760 = 0.6 X – 30,400
500
2,000
X = `91,467
(e) (i) Calculation of Financial Break Even Point
Amount in (`)
Particulars
Present Plan Debt Plan Equity Plan
A. Interest on Debt
44,000
74,600
44,000
B. Preference Dividend after Grossing up for Tax
Preference Dividend
6,667
6,667
6,667
(1 – t)
C. Financial Break Even Point [A + B]
50,667
81,267
50,667
(f)
Calculation of Indifference Point at which UEPS will be same
(x – 74,600) (1 – 0.4) - 4,000 - 50,000 = (x – 44,000) (1 – 0.4) – 4,000 – 50,000
500
2,000
0.6X – 98,760 = 0.6X – 80,400
500
2000
X = `1,74,800
(g) At the Indifference Points though the EPS under both Plans will be same, but the P/E Ratio under both Plans is not same.
P/E Ratio for Debt Plan is 4 and P/E Ratio for Equity Plan is 10. Therefore, market price of Shares under both Plans will be
different at the Indifferent Point.
(h) Post tax Cost of new debt Kd = I(1-t) = `30,600 (1 – 0.4) = 7.34%
NP
`2,50,000
Post tax Cost of new equity Ke = Equity Dividends on New Shares = `26,700 = 10.68%
Net Proceeds of New Shares
`2,50,000
Working Notes:
(i) Calculation of Total Funds Required
= (50% of Total Assets) + Flotation Cost
= [50% of (Debt + Equity + Pref. Share Capital)] + Flotation Cost
= [50% of `44,000 + 5,600 x 100 + 4,000 + `5,000
11%
11.20
8%
= [50% of (`4,00,000 + `50,000 + `50,000)] + `5,000 = `2,55,000
(ii) No. of New Equity Shares to be issued = `2,55,000/(`100 + `70) = 1,500.
(iii) Amount of new interest expense = `2,55,000 x 12%
= `30,600
(iv) Amount of equity dividends on new equity shares = `17.80 x 1,500 shares