Corporate Finance Capital structure Theories Questions Q1. . Mahima Ltd has a net operating income of Rs 30 million. The company employs Rs 100 million debt
carrying 10% interest charges. The cost of equity is 15%. What is the market value of the firm under NI approach? Assume that there are no taxes Q2. The management of Samata Company subscribing to Net operating Income Approach, believe that
its cost of debt and overall cost of capital will remain at 8% and 12% respectively. If the equity shareholders demand a return of 20%, what should be the proportion of debt and equity in the firm’s capital structure? Assume that there are no taxes. Q3. The following information is available for Avinash Metals
Net operating income
Rs 40 million
Interest on debt
Rs 10 million
Cost of equity
18%
Cost of debt
12%
a.
What is the average cost of capital of Avinash?
b. What happens to the average cost of capital of Avinash if it employs Rs 100 debt for a new project which earns an operating income of Rs20 million. Assume NOI method applies and there are no taxes Q4. The management of Vaibhav fabrics subscribes to NOI approach and believes that its cost of debt
and overall cost of capital will remain at 9% and 12% respectively. If debt equity ratio is 0.8, what is the cost of equity? Q5. The following information is available for two firms, Box Corporation and Cox Cor poration
Net operating income Interest on debt Cost of equity Cost of debt
Box 20,00,000 15% 10%
Cox 20,00,000 5,00,000 15% 10%
Calculate the market value of equity, market value of debt and market value of both the firms? a.
What is the average cost of capital for each firm?
b. What happens to the average cost of capital of Box Corporation if it employs Rs 30 million of debt to finance a project that yields an operating income of Rs 4 million? c.
What happens to the the average cost of capital of Cox Corporation if it sells Rs 10 million of additional equity (at par) to retire Rs 10 million of outstanding debt? 1
Dr. Gitika Mayank, Asst Professor, Finance
Q6. Ram Ltd and Shyam Ltd belong to the same risk class – these companies are identical in all respects except that Ram ltd has no debt in its capital structure. The relevant financial pa rticulars of the two companies are given below Ram Ltd 10,00,000 10,00,000 14%
Shyam Ltd Net operating income 10,00,000 Debt interest 3,00,000 Equity earnings 7,00,000 Debt capitalization rate 10% Equity capitalization rate 10% Market value of debt 30,00,000 Market value of equity 7142857 38,88888 Market value of the firm 7142857 68,88,888 Average cost of capital 14% 14.52% Praveen owns Rs 1, 00,000 worth of Ram Ltd equity. What arbitrage can he resort to? Q7. The two companies, U and L belong to an equivalent risk class. These two firms are identical in every respect except that U company is unleveled while company L has 10% debentures of Rs 30 lakh. The other relevant information regarding their valuation and capitalization rates are as follows: Particulars Firm U Firm L EBIT 7,50,000 7,50,000 Interest 3,00,000 NI 7,50,000 4,50,000 Equity capitalization rate 0.15 0.20 Market value of equity 50,00,000 22,50,000 Market value of debt 30,00,000 Total value 50,00,000 52,50,000 Ko 0.15. 0.143 Debt/equity 0 1.33 an investor owns 10% equity shares of company L. show the arbitrage process and the amount by which i. he could reduce the his outlay through the use of leverage. ii.
According to Modigliani and Miller when will this process come to an end?
Q8. Consider the following information of Optima Ltd
Net operating income
Rs 210 million
Corporate tax rate
30%
Market (as well as book value)
Rs 300 million
Capitalization rate applicable to a debt free
firm in the risk class to which optima belongs
16%
What will be the value of Optima Ltd according to MM approach?
2
Dr. Gitika Mayank, Asst Professor, Finance
3
Dr. Gitika Mayank, Asst Professor, Finance
