Cases on capital structure

1. A firm has the requirement of Rs. 200 towards investment in total assets. The firm is contemplating to fund the same through
common equity and borrowed funds. Prove that increasing leverage of the firm will lower WACC and enhance the value of
the firm as per Net Income (NI) approach. Apart from the assumptions of NI approach, you may note the following additional
information.
a. Ke and Kd are 16% and 10% at all levels of leverage.
b. Expected EBIT of the firm is Rs. 80

2. A firm has the requirement of Rs. 800,000 towards investment in total assets. The firm is contemplating to raise the same
through common equity and borrowed funds. The shareholders are sensitive to the leverage and hence expect higher return
for increased leverage, as mentioned in the table below.

Ke 12.50% 15.00% 16.67% 20.00% 30.00% 0.00%

Debt (Rs.) 0 400000 500000 600000 700000 800000

Prove that increasing leverage of the firm will not lower WACC and will not enhance the value of the firm as well as per Net
Operating Income (NOI) approach. Apart from the assumptions of NOI approach, you may note the following additional
information.
a. Kd is 10% at all levels of leverage.
b. Expected EBIT of the firm is Rs. 100,000.
3. The table below contains capital structure details of levered and un-levered firms.

Un-levered Levered
Equity Rs 800 400
Debt @ 5% 0 400
Total Capital Rs. 800 800
Ke (%) 12.50% 16%
EBIT Rs. 100 100
a. Assuming that you hold 10% stake in levered firm, what is your profit?
b. Assuming you have an opportunity to borrow at the same rate as that of levered firm and move to un-levered firm
with the same 10% stake, will your profit maximize?
Morales Publishing Inc., Integrative ---- Optimal Capital Structure

The board of directors of Morales Publishing, Inc., has commissioned a capital structure study. The company has total assets of
$40,000,000. It has earnings before interest and taxes of $8,000,000 and it is taxed at 40%.

a. Create a spread sheet showing values of debt and equity as well as the total number of shares, assuming a book value of $25
per share.

No. of Shares
Debt (%) Total Assets in $ Debt in $ Equity in $
@ $25
0 40,000,000
10 40,000,000
20 40,000,000
30 40,000,000
40 40,000,000
50 40,000,000
60 40,000,000

b. Given the before tax cost of debt at various levels of indebtedness, calculate the yearly interest expenses.

Interest
Debt (%) Total Debt in $ Before tax kd (%)
Expenses in $
0 0 0
10 7.5
20 8
30 9
40 11
50 12.5
60 15.5

c. Using EBIT of $8,000,000, a tax rate of 40%, and information developed in parts ‘a’ and ‘b’, calculate the most likely
earnings per share for the firm at various levels of indebtedness. Mark the levels of indebtedness that maximizes EPS.

Interest
Debt (%) EBIT in $ Taxes Net Income No. of Shares EPS
Expenses
0 8,000,000
10 8,000,000
20 8,000,000
30 8,000,000
40 8,000,000
50 8,000,000
60 8,000,000
 d. Using EPS developed in part ‘c’ and given estimates of required return i.e ke, estimate the value per share at various levels of
indebtedness. Mark the level of indebtedness that results in the maximum price per share.

Debt (%) EPS ke (%) Price per Share

0 10
10 10.3
20 10.9
30 11.4
40 12.6
50 14.8
60 17.5

e. Prepare a recommendation to the board of Morales Publishing, Inc., that specifies the degree of indebtedness that will
accomplish the firm’s goal of optimizing shareholder wealth. Use your findings in parts ‘a’ through‘d’ to justify your
recommendations.

P.S: The above case study is taken from Principles of Managerial finance, Lawrence J. gitman, ninth Edition, page 535 challenge
problem 12-23.

Apex Ltd. Optimum Capital Structure

The Apex Limited is a newly incorporated company and wants to plan an appropriate capital structure. It can issue 9 percent debt
and 11 percent preference capital and has a 35 percent tax rate. The firm’s initial requirements for funds are Rs.400 lakh and equity
shares can be sold for a net price of Rs.25 per share. The possible capital structures are:

Alternative Equity (in %) Preference Equity (in %) Debentures (in %)

1 100 0 0
2 75 0 25
3 75 25 0
4 50 20 30
5 50 0 50
6 30 20 50
Construct EBIT-EPS chart for six alternatives over an EBIT range of Rs.10 lakh to Rs.80 lakh. Also suggest an optimum alternative for
each level of EBIT such that EPS of the company is maximized.

Evaluating Tampa Manufacturing’s (www.tampa-g.com) Capital Structure

Tampa Manufacturing, an established producer of printing equipment, expects its sales to remain flat for the next 3 to 5 years due to
both a weak economic outlook and an expectation of little new printing technology development over that period. On the basis of this
scenario, the firm’s management has been instructed by its board to institute programs that will allow it to operate more efficiently,
earn higher profits, and most important, maximize share value. In this regard, the firm’s chief financial officer (CFO), Jon Lawson,
has been charged with evaluating the firm’s capital structure. Lawson believes that the current capital structure, which contains 10%
debt and 90% equity, may lack adequate financial leverage. To evaluate the firm’s capital structure, Lawson has gathered the data
summarized in the following table on the current capital structure (10% debt ratio) and two alternative capital structures ------ A (30%
debt ratio) and B (50% debt ratio) ----- that he would like to consider.

Capital Structure
Alternatives →
Current (10% debt) 30% debt 50% debt
Sources ↓
Long-term debt $1,000,000 $3,000,000 $5,000,000
 (coupon rate) (9%) (10%) (12%)
Common stock 100,000 shares 70,000 shares 40,000 shares
(required rate of return, ke) (12%) (13%) (18%)

Lawson expects the firm’s EBIT to remain at its current level of $1,200,000. The firm has a 40% tax rate.

Required:

a. Use the current level of EBIT to calculate the times interest earned ratio for each capital structure. Evaluate the current and
two alternative capital structures using the times interest earned and debt ratios.
b. Prepare a single EBIT – EPS graph showing the current and two alternative capital structures.
c. On the basis of the graph in ‘b’, which capital structure will maximize Tampa’s EPS as its expected level of EBIT of
$1,200,000? Why might this not be the best capital structure?
d. Using the zero growth valuation model, find the market value of Tampa’s equity under each of the three capital structures at
the $1,200,000 level of expected EBIT.

e. On the basis of your findings in ‘c’ and ‘d’, which capital structure would you recommend? Why?
To optimize on EPS as well as value of equity, a capital structure with 30% debt is recommended as it maximizes the equity
value and gives a better EPS than the EPS provided by the current capital structure.

P.S: The above case studies are taken from Principles of Managerial finance, Lawrence J. Gitman, ninth Edition.