CA- Intermediate Test Cost of Capital, Capital Structure & Leverages

CA- Intermediate Test Cost of Capital, Capital Structure & Leverages Maximum Time: 200 Minutes Total Marks: 100 Question 1: Solution: Calculation of arnings per share for three alternatives to finance the project: I II III arnings Before Interest and Tax 5,00,000 5,00,000 5,00,000 Less: Interest on Debt (25,000) (1,37,500) (2,37,500) arnings Before Tax 4,75,000 3,62,500 2,62,500 Less: Tax @ 50% (2,37,500) (1,81,250) (1,31,250) arnings After Tax: (A) 2,37,500 1,81,250 1,31,250 Number of quity shares: (B) 15,000 10,000 8,000 arnings per share: (A)/(B) 15.833 18.125 16.406 Decisions: The earning per share is higher in alternative II i.e if the company finance the project by raising debt of `10,00,000 and issue equity shares of `15,00,000. Therefore the company should choose this alternative to finance the project. Working Notes: (1) Computation of Interest under each option I II III Interest on Debt 25,000 1,37,500 2,37,500 (10% on `2,50,000) (10% on `2,50,000) (10% on `2,50,000) (15% on `7,50,000) (15% on `7,50,000) (20% on `5,00,000) (2) Computation of Number of quity Shares under each option I II III quity Financing: (A) `22,50,000 `15,00,000 `10,00,000 Market Price per share: (B) `150 `150 `125 Number of quity Share: (A)/(B) 15,000 10,000 8,000 Question 2: Solution: (a) DOL = 1.50 DOL = Contribution = C. Contribution Fixed Cost C F 1.5 (C - 10) = C Or 1.5C 1.5 x 10 = C Or (1.5-1) C = 15 Or 0.5 C = 15 Or C = `30 Lakh BIT = Contribution Fixed Cost = `30 Lakhs `10 Lakhs = `20 Lakhs DFL = BIT/(BIT - I) = 20/(20-6) or DFL = 1.43 (b) DTL = DOL x DFL = 1.5 x 1.43 = 2.145 1 P a g e

(c) If a decline in sales causes the profit before tax to be zero then profit after tax and PS will also be zero. DTL = % Change in PS % Change in Sales 2.145 = 100%. % Change in Sales % Change in Sales = 100% = 46.62% 2.145 A decline in sales by 46.62% will wipe out the entire profit before tax. Question 3: (a) Solution: At the financial break even point, PS = 0 The amount of BIT at the financial break even point = I + Dp. 1 - t = 100(0.13) + 100(0.12) = `33 lakh 1 0.40 (b) Solution: At the overall break even point, PS = 0, Sales quantity at the overall break even point = Q = F + I + Dp. (1 - T) (S - V) Given, Financial break even point = I + Dp. (1 - T) = `1,50,000 Operating break even point = F = 50,000 (S - V) Also given that contribution per unit (i.e. S - V) = 10 Therefore, fixed costs (F) = 10 x 50,000 = `5,00,000 Hence, Sales quantity at the overall break even point = 5,00,000 + 1,50,000 = 65,000 units 10 (c) Solution: Degree of operating leverage = Q (P -V). Q (P V) - F Present sales quantity = 900 = 18 lakh units 50 DOL = 18(50-30) = 6 18(50-30) - 300 DOL = Present change required in BIT Percentage change in sales Percentage change in quantity sold required to increase BIT by 30% = Percentage change required in BIT = 30 = 5% increase DOL 6 (d) Solution: RO = ROI (1 t) + D (ROI I) (1 t) Substituting the values given 0.165 = 0.15 (1 0.40) + D (0.15 0.10) (1 0.40) 0.165 = 0.09 + D x 0.03 0.075 = D x 0.03 2 P a g e

= D = 2.5 Therefore, Infotech Ltd. should adopt a financial leverage of 2.5 to obtain the target RO of 16.5%... Question 4: Solution: BT = Net Profit + Taxes = ` 196 + ` 84 = ` 280 Crore BIT = BT + Interest = `280 + `75 = `355 Crore t = Taxes = 84 = 0.3 Net Profit + Taxes 196 + 84 Preference Dividends = (150 x 12%) = ` 18 Crore DFL = BIT BT Preference Dividends (1 - t) = 355 1.396 280 18. (1 0.3) Question 5: Solution: (i) Determination of PS at BIT level of `22,00,000 Financing Plan (a) (b) (c) quity Shares (`) Debentures (`) Pref. Shares (`) BIT 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) AT 15,28,800 14,55,300 15,28,800 Less: Dividend on Pref. Shares (20,000) (20,000) (1,18,000) arnings available for equity shares 15,08,800 14,35,300 14,10,800 Number of quity Shares 90,000 80,000 80,000 PS (`) 16.76 17.94 17.64 (ii) quivalency level of arnings between quity & 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) quivalency 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 3 P a g e

0.7X = `9,13,200 X = `9,13,200 0.7 = `13,04,571 Question 6: Solution: (`) in million Net operating income 40 Less: Interest on debt capital (`90 million x 8%) (7.2) arnings available to equity shareholders 32.8 quity capitalization rate 16% Market value of equity 205 Market value of debt 90 Total value of the firm 295 Question 7: Solution: (i) Calculation of Value of Firm (VF) under Traditional approach: Value of Firm = Value of Debt + Value of quity BIT 4,00,000 Less: Interest (10,00,000 x 10%) (1,00,000) arnings Available for quity (A) 3,00,000 quity Capitalisation Rate (Ke) 15% Value of quity (A/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) = BIT x 100 Value of Firm = `4,00,000 x 100 = 13.33% `30,00,000 Leverage Ratios (a) Debt quity Ratio = Debt = `10,00,000 = 0.5:1 quity `20,00,000 (b) Debt to Total Funds = Debt = `10,00,000 = 0.33:1 Debt + quity `30,00,000 Question 8: Solution: (i) Statement showing Computation of Weighted Average Cost of Capital Source Weights Cost of Capital (%) Weighted Average Cost of Capital (%) quity Share Capital 20,00,000 0.50 14%* 7% 12% Preference Share Capital 8,00,000 0.20 12% 2.4% 10% Debentures 12,00,000 0.30 10% (1 0.40) = 6% 1.8% 40,00,000 1.00 11.2% *Cost of quity, Ke = D1 + g P0 = `10 + 0.06 = 14% `125 (ii) Degree of Financial Leverage (DFL) = BIT. BT Preference Dividends (1 - t) 4 P a g e

= `8,40,000. `8,40,000 (10% of `12,00,000) 12% of `8,00,000 (1 0.40) = `8,40,000. `7,20,000 - `1,60,000 = 1.50 times (iii) Statement showing Computation of Revised Weighted Average Cost of Capital Source Weights Cost of Capital (%) Weighted Average Cost of Capital (%) quity Share Capital 20,00,000 0.3333 16%* 5.3328% 12% Preference Share Capital 8,00,000 0.1333 12% 1.5996% 10% Debentures 12,00,000 0.2000 6% 1.2000% 15% Loan 20,00,000 0.3334 15% (1 0.40) = 9% 3.0006% 60,00,000 1.0000 11.133% *Cost of quity, Ke = D1 + g P0 = `12 + 0.06 = 16% `120 (iv) Degree of Financial Leverage (DFL) = BIT, BT Preference Dividends (1 - t) = `8,40,000 + `3,20,000 `11,60,000 (10% of `12,00,000) 15% of 20,00,000-12% of `8,00,000 (1 0.40) = `11,60,000 `7,40,000 - `1,60,000 = 2 times (v) Degree of Operating Leverage (DOL) = Contribution BIT 3 = Contribution `11,60,000 Contribution = `34,80,000 P/V Ratio = Contribution x 100 Sales 40% = `34,80,000 x 100 Sales Sales = `87,00,000 Question 9: Solution: (i) Income Statement Contribution 3,90,000 Less: Operating Fixed Cost (90,000) BIT 3,00,000 Less: Interest (10% of `4,00,000) (40,000) BT 2,60,000 Less: Tax (30%) (78,000) AT/PAT 1,82,000 Less: Preference Dividend (8% of 6,25,000) (50,000) A 1,32,000 Operating Leverage = Contribution BIT 5 P a g e

= `3,90,000 `3,00,000 = 1.3 times Financial Leverage = BIT. BT Preference Dividend 1 - tax = 3,00,000. 2,60,000 50,000 1 0.30 = 1.59 times (ii) Ke = D0 (1 + g) + g P0 Where, D0 = quity Dividend paid = 15% of `10 = `1.5 g = growth rate = 5% P0 = Market Price per share = `20 Ke = `1.5 ( 1 + 0.05) + 0.05 `20 Ke = 12.875% Question 10: Solution: (i) Post tax Kd = I(1 t) = 12% (1 0.40) = 7.2% P 100 Ke = D0 (1 + g) + g = 3.6 (1.09) + 0.09 = 16.27% P0 54 P0 = 54 D0 = 3.60 g = 9% NP = 95 Kp = D = `11 = 11.58% NP 95 (ii) WACC = (Kd x WD) + (Kp x Wp) + (Ke x We) = (7.2% + 0.25) + (11.58% x 15) + (16.27% + 0.60) = 13.30% (iii) PS of last year = DPS of last year Dividend payout = `3.60 = `12 30% xpected PS = PS of Last year x (1 + g) = 12(1 + 0.9) = `13.08 No. of quity Shares = xpected Net Income this year xpected PS this year = 26,16,000 = 2,00,000 shares 13.08 Question 11: Solution: Kd = I (1- t) + (RV NP) /n (NP + RP) / 2 = 80 ( 1 0.55) + (1,000 960)/20 = 3.88% (1000 + 960)/2 Kp = D + (RV NP) /n (NP + RP) / 2 6 P a g e

= 1 + (10 9.5) /15 = 10.60% (9.5 + 10)/2 Ke = D1 + g P0 = 20 + 0.05 = 15% 200 Statement showing Computation of Weighted Average Cost of Capital (Book Value weights) Capital Structure Amount (`) Weights C.O.C WACC Debentures Preference Shares quity Share Capital 16,00,000 4,00,000 20,00,000 0.40 0.10 0.50 3.88% 10.60% 15.00% 1.55% 1.06% 7.50% 40,00,000 1.00 Ko = 10.11% Statement showing Computation of Weighted Average Cost of Capital (Market Value weights) Capital Structure Amount (`) Weights C.O.C WACC Debentures Preference Shares quity Share Capital 17,60,000 4,80,000 40,00,000 0.282 0.077 0.641 3.88% 10.60% 15.00% 1.09% 0.82% 9.62% 62,40,000 1.000 Ko= 11.53% Question 12: Solution: Total amount of Debt = `15 lakh 13% = `115.38 lakh Total amount of quity = `60 lakh `15 lakh 17% = `264.71 lakh Total Debt & quity = `115.38 lakh + `264.71 lakh = `380.09 lakh Statement showing Computation of Average Cost of Capital Source Amount (` in lakhs) Weight Cost WACC Debt 115.38 0.304 13% 3.952% quity 264.71 0.696 17% 11.832% 380.09 1.00 15.784% Therefore Average Cost of Capital for the firm = 15.78%. Question 13: Solution: Statement showing Calculation of Degree for various Leverages Present Situation (`) Debt Plan (`) quity 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) arnings before Interest & Tax 60,000 1,10,000 1,10,000 Less: Interest (44,000) (74,600) (44,000) arnings before Tax (BT) 16,000 35,400 66,000 Less: Tax @ 40% (6400) (14,160 (26,400) arnings after Tax (AT ) 9,600 21,240 39,600 Less: Pref. Dividend (4,000) (4,000) (4,000) arnings Available for quity Shareholders (A) 5,600 17,240 35,600 7 P a g e

No. of quity Shares 500 500 2.000 (a) Operating Leverage (Contribution/BIT) 2.50 1.82 1.82 Financial Leverage BIT BT Pref. Dividend 1 t 6.429 3.828 1.854 Combined leverage (Operating Leverage x Financial Leverage) 16.07 6.97 3.37 (b) arnings per share (PS) [A/No. of quity Shares] 11.20 34.48 17.80 Percentage Change in PS 207.86% 58.93% Price arning Ratio (P/ Ratio) 10 4 10 (c) Market Price [PS x P/ Ratio] 112 137.92 178 (d) Recommendation: The equity financing should be employed since the market price of an equity share is higher than that under debt financing. (e) 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 2000 X = `91,467 (f) (i) Calculation of Financial Break ven Point Present Plan Debt Plan quity Plan A. Interest on Debt 44,000 74,600 44,000 B. Preference Dividend after Grossing up for Tax Preference Dividend (1 t) 6,667 6,667 6,667 C. Financial Break ven Point [A + B] 50,667 81,267 50,667 (ii) Calculation of Operating Break ven Point Present Plan Debt Plan quity Plan A. Fixed Cost 90,000 90,000 90,000 B. P/V Ratio 25% 25% 25% C. Operating BP (A/B) (in `) 3,60,000 3,60,000 3,60,000 (iii) Calculation of Overall Break ven Point Present Plan Debt Plan quity Plan A. Fixed Cost 90,000 90,000 90,000 B. Interest on Debt 44,000 74,600 44,000 C. Preference Dividend after Grossing up for Tax Preference Dividend (1 t) 6,667 6,667 6,667 D. P/V Ratio 25% 25% 25%. Overall BP (A+B+C/D) (in `) 5,62,668 6,85,068 5,62,668 (g) Calculation of Indifference Point at which UPS 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 (h) At the Indifference Points though the PS under both Plans will be same, but the P/ Ratio under both Plans is not same. P/ Ratio for Debt Plan is 4 and P/ Ratio for quity Plan is 10. Therefore, market price of Shares under both Plans will be different at the Indifferent Point. 8 P a g e

(i) Financial risk under Debt Plan is more on account of the following reasons: (i) Debt Plan has higher Financial Leverage. (ii) Financial BP is higher under Debt Plan as compared to quity Plan. (j) 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 = quity 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 + quity + 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 quity 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 = `26,700 9 P a g e