CA Inter FM-ECO by CA Mayank

Kothari

Chapter 5
Financing Decisions-Capital Structure
Q1. Explain the meaning of the term “Capital Structure”.
Answer:
Capital structure is the combination of capitals from different sources
of finance, primarily consisting of equity share holders’ fund,
preference share capital and long term external debts.
The source and quantum of capital is decided on the basis of need of
the company and the cost of the capital.
However, the prime objective of a company is to maximize the value of
the company while deciding the optimal capital structure.
Q2. How do we calculate value of a firm?
Answer:
The value of firm is calculated as below:
EBIT
Value of the firm =
Overall cost of capital or Weighted average cost of capital

K 0 = (Cost of debt × weight of debt) + (Cost of equity × weight of equity)

K 0 = [{K d × D/(D + S)} + {K e × S/(D + S)}]

Where,
K 0 = Weighted average cost of capital
K d = Cost of Debt
D = Market value of debt
S = Market value of equity
K e = Cost of equity
Q3. What do you mean by capital structure decision? How is it relevant in
maximizing the value of the firm and minimizing overall cost of capital?
Answer:
Capital Structure decision refers to deciding the sources of financing,
the amount to be funded and their relative proportions (mix) in total
capitalization.
Whenever funds are to be raised to finance investments, capital
structure decision is involved.
It helps in deciding weight of debt and equity and ultimately overall
cost of capital as well as Value of the firm.
So ultimately, capital structure is relevant in maximizing value of the
firm and minimizing overall cost of capital.

Q4. There are different approaches taken to explain the relationship between
cost of capital, capital structure and value of the firm. Depict those
approaches.
Answer:
The following are the different approaches:
1. Net Income (NI) Approach
2. Traditional Approach
3. Net Operating Income (NOI) Approach
4. Modigilani-Miller (MM) Approach
Net Income (NI)
Approach
Capital Structure
Relevance Theory Traditional
Approach
Capital Structure
Theories Net Operating
Income (NOI)
Capital Structure Approach
Irrelevance Theory
Modigliani-Miller
(MM) Approach
Q5. To understand the relationship between cost of capital, capital structure and
value of the firm, a number of assumptions are taken. Mention those
assumptions.
Answer:
The assumptions taken while understanding the relationship are mentioned as
below:
There are only two kinds of funds used by a firm i.e. debt and equity.
The total assets of the firm are given. The degree of average can be
changed by selling debt to purchase shares or selling shares to retire
debt.
Taxes are not considered.
The payout ratio is 100%.
The firm’s total financing remains constant.
Business risk is constant over time.
The firm has perpetual life.

Q6. As per the Net Income (NI) Approach, explain how the capital structure
decision affects weighted average cost of capital (WACC) thereby affecting
the value of the firm as well as market price of shares.
Answer:
Capital structure decision primarily helps in deciding weight of debt and
equity and ultimately overall cost of capital as well as Value of the firm
& the market price of shares.
An increase in financial leverage will lead to decline in the weighted
average cost of capital (WACC), while the value of the firm as well as
market price of ordinary share will increase.
Conversely, a decrease in the leverage will cause an increase in the overall
cost of capital and a consequent decline in the value as well as market
price of equity shares. Thus as debt increases, WACC decreases.
Thus, under the NI approach, the value of the firm & market price of
shares will be maximum when WACC is minimum.
On point to remember is that in both the above situation, it is assumed
that K e and K d do not change with leverage.
Q7. How under the Net Income approach (NI), the firm can increase its total
value?
Answer:
Under the NI approach, the value of the firm & market price of shares
will be maximum when WACC is minimum.
Thus according to this approach, the firm can increase its total value by
decreasing its overall cost of capital through increasing the degree of
leverage.
Thus, to achieve highest market price of shares and highest value of the
firm, total or maximum possible debt financing should be done to
minimize the cost of capital.
The significant conclusion of this approach is that it pleads for the firm
to employ as much debt as possible to maximize its value.

Q8. How do we calculate the value of the firm on the basis of Net Income (NI)
Approach?
Answer:
The value of the firm on the basis of Net Income (NI) Approach is given by,
Value of the firm(V) = S + D
Where,
V = Value of the firm
S = Market value of equity
D = Market value of debt

Q9. Provide how market value of equity is calculated.

Answer:
The market value of equity is calculated as below:
NI
Market value of equity (S) =
Ke
Where,
NI = Earnings available for equity shareholders
𝐾�� = Equity Capitalization rate
Q10. How will you calculate overall cost of capital under Net Income (NI)
Approach?
Answer:
The overall cost of capital under this approach is :
Overall cost of capital = EBIT
Value of the firm
Thus according to this approach, the firm can increase its total value
by decreasing its overall cost of capital through increasing the degree
of leverage.
The significant conclusion of this approach is that it pleads for the firm
to employ as much debt as possible to maximize its value.

Q11. Explain traditional approach used to explain the capital structure theory
(that is, the relationship between cost of capital, capital structure and
value of the firm). Also explain with reference to the traditional approach
where optimal capital structure is obtained?
Answer:
Traditional approach favors that as a result of financial leverage up to
some point, cost of capital comes down and value of firm increases.
However, beyond that point, reverse trends emerge.
Under this approach it is believed that there is an optimal capital
structure which minimizes the cost of capital.
At the optimal capital structure, the real marginal cost of debt and
equity is the same.
Before the optimal point, the real marginal cost of debt is less than
real marginal cost of equity and beyond this optimal point the real
marginal cost of debt is more than real marginal cost of equity.
Optimum capital structure occurs at the point where value of the firm is
highest and the cost of capital is the lowest.
Q12. Explain treatment of capital structure decisions under different
approaches used to explain capital structure theory.
Answer:
As per the Net Income approach capital structure decision primarily
helps in deciding weight of debt and equity and ultimately decides
overall cost of capital as well as Value of the firm & the market price
of shares.
However, according to net operating income approach, capital
structure decisions are totally irrelevant.
Modigliani-Miller supports the net operating income approach but
provides behavioral justification.
The traditional approach, on the other hand strikes a balance
between Net operating income approach and Modigliani-Miller
approach (that is, between extremes).

Q13. What according to you are the main highlights of traditional approach?
Answer:
The main highlights of traditional approach are mentioned as below:
a) Capital Structure:
The firm should strive to reach the optimal capital structure and its
total valuation through a judicious use of the both debt and equity
in capital structure.
At the optimal capital structure, the overall cost of capital will be
minimum and the value of the firm will be maximum.
b) Financial Leverage:
Value of the firm increases with financial leverage up to a certain
point.
Beyond this point the increase in financial leverage will increase its
overall cost of capital and hence the value of firm will decline.
This is because the benefits of use of debt may be so large that
even after offsetting the effect of increase in cost of equity, the
overall cost of capital may still go down.
 However, if financial leverage increases beyond an acceptable
limit, the risk of debt investor may also increase, consequently cost
of debt also starts increasing.
The increasing cost of equity owing to increased financial risk and
increasing cost of debt makes the overall cost of capital to
increase.

Q14. Explain Net operating Income approach (NOI)?

Answer:
Net operating Income means earnings before interest and tax (EBIT).
According to this approach, capital structure decisions of the firm are
irrelevant.
Any change in the leverage will not lead to any change in the total
value of the firm and the market price of shares, as the overall cost of
capital is independent of the degree of leverage.
As a result, the division between debt and equity is irrelevant.
As per this approach, an increase in the use of debt which is
apparently cheaper is offset by an increase in the equity capitalization
rate.
This happens because equity investors seek higher compensation as they
are opposed to greater risk due to the existence of fixed return
securities in the capital structure.

Q15. Explain how Modigliani-Miller approach (MM) is different from Net

operating Income approach (NOI)? Also mention how Modigliani-Miller
approach is classified.
Answer:
The NOI approach is conceptual and lacks behavioral significance. It does
not provide operational justification for irrelevance of capital
structure.
However, Modigliani-Miller’s approach provides behavioral
justification for constant overall cost of capital and therefore, totals
value of the firm.
 Modigliani-Miller approach can be classified as below:
A. MM approach-1958 : without tax
B. MM approach-1963 : with tax

Q16. Briefly explain “MM approach-1958: without tax”. Also mention

assumptions considered under this approach.
Answer:
This approach describes that in a perfect capital market where there is
no transaction cost and no taxes, the value and cost of capital of a
company remain unchanged irrespective of change in the capital
structure.
The approach is based on further additional assumptions like:
1. Capital markets are perfect. All information is freely available and
there are no transaction costs.
2. All investors are rational.
3. Firms can be grouped into ‘Equivalent risk classes’ on the basis of
their business risk.
4. Non-existence of corporate taxes.

Q17. Briefly mention the propositions derived based on the assumptions under
Modigliani-Miller approach.
Answer:
The following propositions have been derived based on the assumptions under
Modigliani-Miller approach:
i. Total market value of a firm is equal to its expected net operating
income divided by the discount rate appropriate to its risk class
decided by the market.
Value of levered firm(Vg ) = Value of unlevered firm(Vu )

Net Operating Income (NOI)

Value ofa firm =
K0
ii. A firm having debt in capital structure has higher cost of equity than
an unlevered firm. The cost of equity will include risk premium for
 the financial risk. The cost of equity in a levered firm is determined as
under:
Debt
K e = K 0 + (K 0 − K d )
Equity
iii. The structure of the capital (financial leverage) does not affect the
overall cost of capital. The cost of capital is only affected by the
business risk.

Q18. Explain the operational justification of Modigliani-Miller approach.

Answer:
The operational justification of Modigliani-Miller hypothesis is
explained through the functioning of the arbitrage process and
substitution of corporate leverage by personal leverage.
Arbitrage refers to buying asset or security at lower price in one
market and selling it at a higher price in another market. As a result,
equilibrium is attained in different markets.
This is illustrated by taking two identical firms of which one has debt in
the capital structure while the other does not.
Investors of the firm whose value is higher will sell their shares and
instead buy the shares of the firm whose value is lower.
They will be able to earn the same return at lower outlay with the
same perceived risk or lower risk. They would, therefore, be better
off.
The value of the levered firm can neither be greater nor lower than
that of an unlevered firm according this approach.
The two must be equal. There is neither advantage nor disadvantage
in using debt in the firm’s capital structure.
No matter how the capital structure of a firm is divided (among debt,
equity etc.), there is a conservation of investment value.
Since the total investment value of a corporation depends upon its
underlying profitability and risk, it is invariant with respect to relative
changes in the firm’s financial capitalization.
 According to MM, since the sum of the parts must equal the whole,
therefore, regardless of the financing mix, the total value of the firm
stays the same.

Q19. Explain the shortcomings of Modigliani-Miller approach.

Answer:
The main shortcoming of this approach is that the arbitrage process as suggested
by Modigliani-Miller will fail to work because of:
a) Imperfections in capital market,
b) Existence of transaction cost and
c) Presence of corporate income taxes.

Q20. Briefly explain the MM approach-1963: with tax.

Answer:
In 1963, MM model was amended by incorporating tax.
They recognized that the value of the firm will increase or cost of
capital will decrease where corporate taxes exist.
As a result, there will be some difference in the earnings of equity and
debt-holders in levered and unlevered firm and value of levered firm
will be greater than the value of unlevered firm by an amount equal
to amount of debt multiplied by corporate tax rate.
MM has developed the following formulae for computation of cost of
capital (𝐾�� ), cost of equity (𝐾�� ) for the levered firm.
1. Value of levered company = Value of unlevered company + Tax benefit
Or,
Vg = Vu + TB
Debt
2. Cost of equity in a levered firm(K eg ) = K eu + (K eu − K d ) Debt+Equity
Where,
K eg = Cost of equity in a levered company
K eu = Cost of equity in an unlevered company
K d = Cost of debt
t = Tax rate
 3. WACC in a levered company(K og ) = K eu (1 − tL)
Where,
K og = WACC of levered company
K eu = Cost of equity in an unlevered company
T = Tax Rate
Debt
L =
Debt + Equity

Q21. Briefly explain the trade-off theory of capital structure as per Modigliani-
Miller approach?
Answer:
The trade-off theory of capital structure refers to the idea that a
company chooses how much debt finance and how much equity
finance to use by balancing the costs and benefits.
An important purpose of the trade-off theory of capital structure is to
explain the fact that corporations usually are financed partly with
debt and partly with equity.
It states that there is an advantage to financing with debt, the tax
benefits of debt and there is a cost of financing with debt, the costs of
financial distress including bankruptcy costs of debt and non-
bankruptcy costs (e.g. staff leaving, suppliers demanding
disadvantageous payment terms, bondholder/stockholder infighting,
etc.).
The marginal benefit of further increases in debt declines as debt
increases, while the marginal cost increases, so that a firm that is
optimizing its overall value will focus on this trade-off when choosing
how much debt and equity to use for financing.
According to Modigliani and Miller, the attractiveness of debt
decreases with the personal tax on the interest income.
Q22. Briefly explain the different concepts that the trade-off theory of capital
structure primarily deals with.
Answer:
Trade-off theory of capital structure primarily deals with the two concepts - cost
of financial distress and agency costs.
A. Financial Distress cost or Bankruptcy cost of debt:
A firm experiences financial distress when the firm is unable to
cope with the debt holders’ obligations.
If the firm continues to fail in making payments to the debt
holders, the firm can even be insolvent.
The direct cost of financial distress refers to the cost of
insolvency of a company.
Once the proceedings of insolvency start, the assets of the firm may
have to be sold at distress price, which is generally much lower
than the current values of the assets.
Also a huge amount of administrative and legal costs is also
associated with the insolvency.
Even if the company is not insolvent, the financial distress of the
company may include a number of indirect costs like – cost of
employees, cost of customers, cost of suppliers, cost of investors,
cost of managers and cost of shareholders.
B. Agency Cost:
The firms may often experience a dispute of interests among the
management of the firm, debt holders and shareholders.
These disputes generally give birth to agency problems that in
turn give rise to the agency costs.
The agency costs may affect the capital structure of a firm.
There may be two types of conflicts - shareholders-managers
conflict and shareholders- debt-holders conflict.
Q23. Briefly explain the concept of Pecking Order theory.
Answer:
This theory is based on Asymmetric information, which refers to a
situation in which different parties have different information.
In a firm, managers will have better information than investors.
This theory states that firms prefer to issue debt when they are
positive about future earnings. Equity is issued when they are
doubtful and internal finance is insufficient.
The pecking order theory argues that the capital structure decision is
affected by manager’s choice of a source of capital that gives higher
priority to sources that reveal the least amount of information.
The name ‘PECKING ORDER’ theory is given as there is no well-defined
debt equity target and there are two kind of equity internal and
external.
Pecking order theory suggests that managers may use various sources
for raising fund in the following order.
1. Managers first choice is to use internal finance
2. In absence of internal finance they can use secured debt,
unsecured debt, hybrid debt etc.
3. Managers may issue new equity shares as a last option.
So briefly under this theory rules are
Rule 1: Use internal financing first.
Rule 2: Issue debt next
Rule 3: Issue of new equity shares at last

Q24. Mention the different sources from which a firm can choose to raise funds.
Answer:
A firm has the choice to raise funds for financing its investment proposals from
different sources in different proportions. They are mentioned as below:
a) Exclusively use debt (in case of existing company), or
b) Exclusively use equity capital, or
c) Exclusively use preference share capital (in case of existing company),
or
 d) Use a combination of debt and equity in different proportions, or
e) Use a combination of debt, equity and preference capital in different
proportions, or
f) Use a combination of debt and preference capital in different
proportion (in case of existing company).

NOTE: The choice of the combination of these sources is called capital structure
mix.

Q25. While choosing a suitable financing pattern, certain fundamental principles

should be kept in minds, to design capital structure. Mention and briefly
explain those fundamental principles.
Answer:
The fundamental principles have been explained below:
1. Financial leverage of Trading on Equity:
The use of long-term fixed interest bearing debt and preference
share capital along with equity share capital is called financial
leverage or trading on equity.
The use of long-term debt increases the earnings per share if the
firm yields a return higher than the cost of debt.
The earnings per share also increase with the use of preference
share capital but due to the fact that interest is allowed to be
deducted while computing tax, the leverage impact of debt is
much more.
However, leverage can operate adversely also if the rate of
interest on long-term loan is more than the expected rate of
earnings of the firm.
Therefore, it needs caution to plan the capital structure of a firm.
2. Growth and stability of sales:
The capital structure of a firm is highly influenced by the growth
and stability of its sale.
If the sales of a firm are expected to remain fairly stable, it can
raise a higher level of debt.
 Similarly, the rate of the growth in sales also affects the capital
structure decision.
Usually, greater the rate of growth of sales, greater can be the
use of debt in the financing of firm.
On the other hand, if the sales of a firm are highly fluctuating or
declining, it should not employ, as far as possible, debt financing
in its capital structure.
3. Cost Principle:
According to this principle, an ideal pattern or capital structure is
one that minimizes cost of capital structure and maximizes
earnings per share (EPS).
For e.g. Debt capital is cheaper than equity capital from the point of
its cost and interest being deductible for income tax purpose,
whereas no such deduction is allowed for dividends.
4. Risk Principle:
According to this principle, reliance is placed more on common
equity for financing capital requirements than excessive use of
debt.
Use of more and more debt means higher commitment in form
of interest payout.
This would lead to erosion of shareholders’ value in unfavorable
business situation.
There are two risks associated with this principle:
i. Business risk:
It is an unavoidable risk because of the environment in
which the firm has to operate and it 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
firm products, variations in prices and proportion of
fixed cost in total cost.
 ii. Financial risk:
It is a risk associated with the availability of earnings
per share caused by use of financial leverage.
It is the additional risk borne by the shareholders when
a firm uses debt in addition to equity financing.
Generally, a firm should neither be exposed to high
degree of business risk and low degree of financial risk
or vice-versa, so that shareholders do not bear a higher
risk.
5. Control Principle:
While designing a capital structure, the finance manager may
also keep in mind that existing management control and
ownership remains undisturbed.
Issue of new equity will dilute existing control pattern and also it
involves higher cost.
Issue of more debt causes no dilution in control, but causes a higher
degree of financial risk.
6. Flexibility Principle:
By flexibility it means that the management chooses such a
combination of sources of financing which it finds easier to adjust
according to changes in need of funds in future too.
While debt could be interchanged (If the company is loaded with a
debt of 18% and funds are available at 15%, it can return old debt
with new debt, at a lesser interest rate), but the same
option may not be available in case of equity investment.
7. Other Consideration:
Besides above principles, other factors such as nature of industry,
timing of issue and competition in the industry should also be
considered.
Industries facing severe competition also resort to more equity
than debt.
Q26. Briefly explain the key concepts for designing optimal structure.
Answer:
The capital structure decisions influence debt–equity mix which
ultimately affects shareholder’s return and risk.
Since cost of debt is cheaper, firm prefers to borrow rather than to
raise money from equity. So long as return on investment is more
than the cost of borrowing, extra borrowing increases the earnings
per share.
However, beyond a limit, it increases the risk and share price may fall
because shareholders may assume that their investment is associated
with more risk.
The major key concepts for designing optimal structure is explained as
below:
a. Leverages:
There are two leverages associated with the study of capital
structure, namely operating leverage and financial leverage.
However, the determination of optimal level of debt is a
formidable task and is a major policy decision which 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 level of debt-equity mix.
b. Coverage Ratio:
The ability of the firm to use debt in the capital structure can
also be judged in terms of coverage ratio namely
EBIT/Interest.
Higher the ratio, greater is the certainty of meeting interest
payments.
 c. Cash flow Analysis:
To determine the debt capacity, cash flow under adverse
conditions should be examined.
A high debt equity ratio is not risky if the company has the
ability to generate cash flows.
It would, therefore, be possible to increase the debt until
cash flows equal the risk set out by debt.
The main drawback of this approach is that it fails to take
into account uncertainty due to technological developments
or changes in political climate.
NOTE:
These approaches as discussed above do not provide solution to the
problem of determining an appropriate level of debt.
However, with the information available a range can be determined
for an optimum level of debt in the capital structure.

Q27. Mention the essential features of a sound capital mix.

Answer:
A sound or an appropriate capital structure should have the following essential
features:
a. Maximum possible use of leverage.
b. The capital structure should be flexible.
c. To avoid undue financial/business risk with the increase of debt.
d. The use of debt should be within the capacity of a firm. The firm
should be in a position to meet its obligation in paying the loan and
interest charges as and when due.
e. It should involve minimum possible risk of loss of control.
f. It must avoid undue restrictions in agreement of debt.
g. The capital structure should be conservative. It should be composed
of high grade securities and debt capacity of the company should
never be exceeded.
 h. The capital structure should be simple in the sense that it can be
easily managed and also easily understood by the investors.
i. The debt should be used to the extent that it does not threaten the
solvency of the firm.

Q28. Briefly explain the meaning of optimal capital structure. Also explain why it
is important to select optimal capital structure.
Answer:
The theory of optimal capital structure deals with the issue of the
right mix of debt and equity in the long term capital structure of a
firm.
This theory states that if a company takes on debt, the value of the
firm increases up to a point.
Beyond that point if debt continues to increase then the value of the
firm will start to decrease.
Also, if the company is unable to repay the debt within the specified
period then it will affect the goodwill of the company and may create
problems for collecting further debt.
Therefore, the company should select its appropriate capital structure
with due consideration to the other factors.

Q29. Briefly why EBIT-EPS analysis is important while designing optimal capital
structure.
Answer:
EBIT-EPS analysis is a vital tool for designing the optimal capital
structure of a company.
The main objective of this analysis is to find the EBIT level that will
equate EPS regardless of the financing plan chosen.
The financial leverage affects the pattern of distribution of operating
profit among various types of investors and increases the variability of
the EPS of the firm.
 Therefore, while searching for an appropriate capitals structure for a
firm, the financial manager must analyze the effects of various
alternative financial leverages on the EPS.
The effect of leverage on the EPS emerges because of the existence of
fixed financial charge (i.e., interest on debt and fixed dividend on
preference share capital).

Q30. Explain how the effect of fixed financial charge on the EPS depends upon
the relationship between the rate of return on assets and the rate of fixed
charge.
Answer:
The effect of fixed financial charge on the EPS extensively depends upon the
relationship between the rate of return on assets and the rate of fixed charge,
which has been explained in the following points:
If the rate of return on assets is higher than the cost of financing, then
the increasing use of fixed charge financing (i.e., debt and preference
share capital) will result in increase in the EPS.
This situation is also known as favorable financial leverage or Trading
on Equity.
On the other hand, if the rate of return on assets is less than the cost
of financing, then the effect may be negative and, therefore, the
increasing use of debt and preference share capital may reduce the
EPS of the firm.

Q31. Briefly explain the reasons why the choice is jilted in favor of debt
financing, while choosing between debt financing and issue of preference
shares at the time of deciding fixed financial charge financing.
Answer:
The fixed financial charge financing may further be analyzed with
reference to the choice between the debt financing and the issue of
preference shares.
Theoretically, the choice is tilted in favor of debt financing for two
reasons:
 i. The explicit cost of debt financing i.e., the rate of interest
payable on debt instruments or loans is generally lower than the
rate of fixed dividend payable on preference shares, and
ii. Interest on debt financing is tax-deductible and therefore the real
cost (after-tax) is lower than the cost of preference share capital.

Q32. Explain the concept of Financial Break-even and Indifference Analysis.

Answer:
A. Financial break-even:
Financial break-even point is the minimum level of EBIT needed
to satisfy all the fixed financial charges i.e. interest and
preference dividends.
It denotes the level of EBIT for which the company’s EPS equals
zero.
If the EBIT is less than the financial breakeven point, then the EPS
will be negative.
But if the expected level of EBIT is more than the breakeven
point, then more fixed costs financing instruments can be taken
in the capital structure, otherwise, equity would be preferred.
B. Indifference Analysis:
One method of considering the impact of various financing
alternatives on earnings per share is to prepare the EBIT chart or
the range of Earnings Chart.
 This chart shows the likely EPS at various probable EBIT levels.
The EPS may go down if another alternative of financing is
chosen even though the EBIT remains at the same level.
At a given EBIT, earnings per share under various alternatives of
financing may be plotted.
A straight line representing the EPS at various levels of EBIT
under the alternative may be drawn.
Wherever this line intersects, it is known as break-even point.
This is known as EPS equivalency point or indifference point since
this shows that, between the two given alternatives of financing
(i.e., regardless of leverage in the financial plans), EPS would be
the same at the given level of EBIT.

Q33. Write down the algebraic formula used to find out the equivalency or
indifference point.
Answer:
The equivalency or indifference point can also be calculated algebraically in the
following manner:
( EBIT − 11 ) ( 1 − T) ( EBIT − 1 2 ) (1 − T)
=
E1 E2
Where,
EBIT = Indifference Point
𝐸1 = Number of equity shares in Alternative 1
𝐸1 = Number of equity shares in Alternative 1
11 = Interest charges in Alternative 1
12 = Interest charges in Alternative 2
Alternative 1 = All Equity Finance
Alternative 2 = Debt-equity Finance

Q34. What are the limitations of EBIT-EPS Analysis?

Answer:
If maximization of the EPS is the only criterion for selecting the
particular debt-equity mix, then that capital structure which is
 expected to result in the highest EPS will always be selected by all the
firms. However, achieving the highest EPS need not be the only goal
of the firm.
The main shortcomings of the EBIT-EPS analysis may be noted as
follows:
i. The EPS criterion ignores the risk dimension:
The EBIT-EPS analysis ignores as to what is the effect of
leverage on the overall risk of the firm.
With every increase in financial leverage, the risk of the firm
and therefore that of investors also increases.
The EBIT-EPS analysis fails to deal with the variability of EPS
and the risk return trade-off.
ii. EPS is more of a performance measure:
The EPS, basically, depends upon the operating profit which,
in turn, depends upon the operating efficiency of the firm.
It is a resultant figure and it is more a measure of
performance rather than a measure of decision making.

Q35. Explain how financial leverage can largely influence the value of the firm
through the cost of capital.
Answer:
The financial leverage has a magnifying effect on earnings per share,
such that for a given level of percentage increase in EBIT, there will be
more than proportionate change in the same direction in the earnings
per share.
The financing decision of the firm is one of the basic conditions
oriented to the achievement of maximization for the shareholders’
wealth.
The capital structure should be selected in such a way that it not only
maximizes the value of the company and wealth of its owners, but
also minimizes the cost of capital.
As a result, the company is able to increase its economic rate of
investment and growth.
 It is important to note that while financing mix cannot affect the total
earnings, it can affect the share of earnings belonging to the
shareholders.

Q36. Explain the concept of over-capitalization & under-capitalization.

Answer:
A. Over-capitalization:
It is a situation where a firm has more capital than it needs or in
other words assets are worth less than its issued share capital,
and earnings are insufficient to pay dividend and interest.
This situation mainly arises when the existing capital is not
effectively utilized on account of fall in earning capacity of the
company while company has raised funds more than its
requirements.
The chief sign of over-capitalization is the fall in payment of
dividend and interest leading to fall in value of the shares of the
company.
B. Under-Capitalization:
It is just reverse of over-capitalization.
It is a state, when its actual capitalization is lower than its proper
capitalization as warranted by its earning capacity.
This situation normally happens with companies which have
insufficient capital but large secret reserves in the form of
considerable appreciation in the values of the fixed assets not
brought into the books.

Q37. Explain briefly the consequences of over-capitalization & under-

capitalization.
Answer:
A. Consequences of Over-Capitalization:
i. Considerable reduction in the rate of dividend and interest
payments.
ii. Reduction in the market price of shares.
 iii. Resorting to “window dressing”.
iv. Some companies may opt for reorganization. However,
sometimes the matter gets worse and the company may go into
liquidation.
B. Consequences of Under-Capitalization:
i. The dividend rate will be higher in comparison to similarly
situated companies.
ii. Market value of shares will be higher than value of shares of
other similar companies because their earning rate being
considerably more than the prevailing rate on such securities.
iii. Real value of shares will be higher than their book value.

Q38. Mention the causes of over-capitalization.

Answer:
Over-capitalization arises due to following reasons:
i. Raising more money through issue of shares or debentures than
company can employ profitably.
ii. Borrowing huge amount at higher rate than rate at which company
can earn.
iii. Excessive payment for the acquisition of fictitious assets such as
goodwill etc.
iv. Improper provision for depreciation, replacement of assets and
distribution of dividends at a higher rate.
v. Wrong estimation of earnings and capitalization.

Q39. What are the possible remedies in case over-capitalization & under-
capitalization occurs?
Answer:
A. Remedies in case over-capitalization:
Following steps may be adopted to avoid the negative consequences
of over-capitalization:
i. Company should go for thorough reorganization.
ii. Buyback of shares.
 iii. Reduction in claims of debenture-holders and creditors.
iv. Value of shares may also be reduced. This will result in sufficient
funds for the company to carry out replacement of assets.
B. Remedies in case under-capitalization:
Following steps may be adopted to avoid the negative consequences
of under capitalization:
i. The shares of the company should be split up. This will reduce
dividend per share, though EPS shall remain unchanged.
ii. Issue of Bonus Shares is the most appropriate measure as this
will reduce both dividend per share and the average rate of
earning.
iii. By revising upward the par value of shares in exchange of the
existing shares held by them.

Q40. Mention the effects of under-capitalization.

Answer:
Under-capitalization has the following effects:
i. It encourages acute competition. High profitability encourages new
entrepreneurs to come into same type of business.
ii. High rate of dividend encourages the workers’ union to demand high
wages.
iii. Normally common people (consumers) start feeling that they are
being exploited.
iv. Management may resort to manipulation of share values.
v. Invite more government control and regulation on the company and
higher taxation also.

Q41. Explain over-capitalization vis-a-vis under-capitalization.

Answer:
Both over capitalisation and under capitalisation are not good.
However, over capitalisation is more dangerous to the company,
shareholders and the society than under capitalisation.
The situation of under capitalisation can be handled more easily than
the situation of over-capitalisation.
Moreover, under capitalisation is not an economic problem but a
problem of adjusting capital structure.
Thus, under capitalisation should be considered less dangerous but both
situations are bad and every company should strive to have a proper
capitalisation.
Practical Questions
1. Yoyo Limited presently has `36, 00,000 in debt outstanding bearing an
interest rate of 10%. It wishes to finance a `40,00,000 expansion program and
is considering three alternatives: additional debt at 12% interest, preferred
stock with an 11% dividend, and the sale of common stock at `16 per share.
The company presently has 8, 00,000 shares of common stock outstanding
and is in a 40% tax bracket.
a. If EBIT are presently 15, 00,000 what would be earnings per share for the
three alternatives, assuming no immediate increase in profitability?
b. Which alternative do you prefer? How much would EBIT need to increase
before the next alternative would be best?

2. A company need `31, 25,000 for the construction of new plant. The following
three plans are feasible.
i. The company may issue 3, 12,500 equity shares at `10 per share.
ii. The company may issue 1, 56,250 ordinary equity shares at `10 per share
and 15,625 debentures of `100 denomination bearing 8% rate of
interest.
iii. The company may issue 1, 56,250 equity shares at `10 per share and
15,625 preference shares at `100 per share bearing an 8% rate of
dividend.
a. IF the company’s earnings before interest and taxes are `62,500, `1,
25,000, `2, 50,000, `3, 75,000 and `6, 25,000, what are the earnings
per share under each of three financial plans? Assume a corporate
income tax rate of 40%.
b. Which alternative would you recommend and why?
Determine the EBIT-EPS indifference points by formulae between Financing
Plan I and Plan II and Plan I and Plan III.
 3. The management of Z Company Ltd. wants to raise its funds from market to
meet out the financial demands of its long term projects. The company has
various combinations of proposals to raise its funds. You are given the
following proposals of the company.
Proposal % of equity % of debt % of preference shares
P 100 - -
Q 50 50 -
R 50 - 50
i. Cost of debt- 10%
ii. Cost of preference shares -10%
iii. Tax rate 50%
iv. Equity shares of the face value of `10 each will be issued at a premium of
`10 per share.
v. Total investment to be raised `40,00,000.
vi. Expected earnings before interest and tax `18,00,000.
From the above proposals the management wants to take advice from you
for appropriate plan after computing the following:
 Earnings per share.
 Financial breakeven point.
 Compute the EBIT range among the plans for indifference. Also indicate if
any of the plans dominate.

4. Ganesha Limited is setting up a project with a capital outlay of `60,00,000. It

has two alternatives in financing the project cost.
Alternative A 100% equity finance
Alternative B Debt-equity ratio 2:1
The rate of interest payable on the debts is 18% p.a. The corporate tax rate is
40%. Calculate the indifference point between the two alternative methods of
financing.
5. Rupa Company’s EBIT is `5, 00,000. The company has 10%, 20lakh
debentures. The equity capitalization rate i.e. K e is 16%.
You are required to calculate:
i. Market value of equity and value of firm
ii. Overall cost of capital.

6. Amita Ltd.’s operating income is `5, 00,000. The firm’s cost of debt is 10% and
currently the firm employs `15, 00,000 of debt. The overall cost of capital of
the firm is 15%.
You are required to determine:
1. Total value of the firm.
2. Cost of equity.

7. There are two firms P and Q which are identical except P does not use any
debt in its capital structure while Q has `8,00,000, 9% debentures in its capital
structure. Both the firms have earnings before interest and tax of `2,60,000
p.a. and the capitalization rate of 10%.
Assuming the corporate tax of 30% calculate the value of these firms
according to MM Hypothesis.

8. One-third of the total market value of Sanghmani Limited consists of loan

stock, which has a cost of 10 per cent. Another company, Samsui Limited, is
identical in every respect to Saghmani Limited, except that its capital structure
is all-equity, and its cost of equity is 16 per cent. According to Modigliani and
Miller, if we ignored taxation and tax relief on debt capital, what would be the
cost of equity of Sanghmani Limited?

9. Shahji Steels Limited requires `25,00,000 for a new plant. This plant is
expected to yield earnings before interest and taxes of `5,00,000. While
deciding about the financial plan, the company considers the objective of
maximizing earnings per share. It has three alternatives to finance the project
- by raising debt of `2,50,000 or `10,00,000 or `15,00,000 and the balance,
in each case, by issuing equity shares. The company's share is currently selling
 at `150, but is expected to decline to `125 in case the funds are borrowed in
excess of `10,00,000. The funds can be borrowed at the rate of 10 percent up
to `2,50,000, at 15 percent over `2,50,000 and up to `10,00,000 and at 20
percent over `10,00,000. The tax rate applicable to the company is 50
percent. Which form of financing should the company choose?

10. Touch screen Limited needs `10,00,000 for expansion. The expansion is
expected to yield an annual EBIT of `1,60,000. In choosing a financial plan,
Touch screen Limited has an objective of maximizing earnings per share. It is
considering the possibility of issuing equity shares and raising debt of
`1,00,000 or `4,00,000 or `6,00,000. The current market price per share is
`25 and is expected to drop to `20 if the funds are borrowed in excess of
`5,00,000. Funds can be borrowed at the rates indicated below: (a) upto
`1,00,000 at 8%; (b) over `1,00,000 up to `5,00,000 at 12%; (c) over
`5,00,000 at 18%. Assume a tax rate of 50 per cent. Determine the EPS for
the three financing alternatives.[Home Work]

11. Ganpati Limited is considering three financing plans. The key information is as
follows:
a. Total investment to be raised `2,00,000
b. Plans of Financing Proportion:
Equity Preference Shares Debt
100% - -
50% - 50%
50% 50% -
c. Cost of debt 8%
Cost of preference shares 8%
c. Tax rate 50%
d. Equity shares of the face value of `10 each will be issued at a premium of
`10 per share.
e. Expected EBIT is `80,000
You are required to determine for each plan:-
i. Earnings Per Share
 ii. The financial breakeven point
iii. Indicate if any of the plans dominate and compute the EBIT range among
the plans for indifference.[Home Work]

12. Indra company has EBIT of `1,00,000. The company makes use of debt and
equity capital. The firm has 10% debentures of `5,00,000 and the firm’s
equity capitalization rate is 15%.
You are required to compute:
1. Current value of the firm
2. Overall cost of capital.[Home Work]

13. The Modern Chemicals Ltd. requires `25,00,000 for a new plant. This plant is
expected to yield earnings before interest and taxes of `5,00,000. While
deciding about the financial plan ,the company considers the objective of
maximising earnings per share. It has three alternatives to finance the
project- by raising debt of `2,50,000 or `10,00,000 or `15,00,000and the
balance, in each case, by issuing equity shares. The company’s share is
currently selling at `150, but is expected to decline to `125 in case the funds
are borrowed in excess of `10,00,000. The funds can be borrowed at the
rate of 10% up to `2,50,000, at 15% over `2,50,000 and up to `10,00,000
and at 20% over `10,00,000. The tax rate applicable to the company is 50%.
Which form of financing should the company choose?[Home Work]

14. A Company earns a profit of `3,00,000 per annum after meeting its Interest
liability of `1,20,000 on 12% debentures. The Tax rate is 50%. The number
of Equity Shares of `10each are 80,000 and the retained earnings amount to
`12,00,000. The company proposes to take up an expansion scheme for
which a sum of `4,00,000 is required. It is anticipated that after expansion,
the company will be able to achieve the same return on investment as at
present. The funds required for expansion can be raised either through debt
at the rate of 12%or by issuing Equity Shares at par.
 Required:
i. Compute the Earnings Per Share (EPS), if:
a. The additional funds were raised as debt
b. The additional funds were raised by issue of equity shares.
ii. Advise the company as to which source of finance is preferable. [Home
Work]

15. Calculate the level of earnings before interest and tax (EBIT) at which the
EPS in difference point between the following financing alternatives will
occur.
i. Equity share capital of `6,00,000 and 12% debentures of `4,00,000 Or
ii. Equity share capital of `4,00,000, 14% preference share capital of
`2,00,000 and 12%debentures of `4,00,000.
Assume the corporate tax rate is 35% and par value of equity share is `10 in
each case. [Home Work]

16. A new project is under consideration in Zip Ltd., which requires a capital
investment of `4.50crore. Interest on term loan is 12% and Corporate Tax
rate is 50%. If the Debt Equity ratio insisted by the financing agencies is 2:1,
calculate the point of indifference for the project. [Home Work]