problems in capital structuring

8/8/2019 Problems in Capital Structuring

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1. Indian Tools Ltd. has developed a financing plan for the next three years based on followingestimates.

(Rs. Lakhs)

Year 1 Year 2 Year 3

Sales 600 720 900

Fixed Assets 480 570 660

The following assumptions have been made for the purpose of planning

Gross Profit 30%

Return on Sales (Net of Taxes) 10%

Dividend payout ratio 50%

Ratios based on year end figures:

Cash and debtors to sales 4 times

Inventory (to cost of goods sold) 3 times

Required current ratio 2 : 1

Required ratio of long-term debt to equity 1 : 2

At the beginning of Year 1 the firm expects to have equity of Rs. 360 lakhs and long-term debt of Rs. 180

lakhs. Determine how much additional equity capital the firm will have to raise each year based on

above ratios and assumptions.

Assume that the company is not seeking separate finance from bank for additional working capital

needs.


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4. Eastern India Ltd. is a profit-making company with a paid-up capital of Rs. 100 lakhs consisting of10 lakh ordinary shares of Rs. 10 each. Currently, it is earning an annual pre-tax profit of Rs. 60

lakhs. The companys shares are listed and are quoted in the range of Rs. 50 to Rs. 80. The

management wants to diversify production and has approved a project which will cost Rs. 50

lakhs and which is expected to yield a pre-tax income of Rs. 40 lakhs per annum. To raise this

additional capital, the following options are under consideration of the management.

(a) To issue equity capital for the entire additional amount. It is expected that the newshares (face value of Rs. 10) can be sold at a premium of Rs. 15.

(b) To issue 16% non-convertible debentures of Rs. 100 each for the entire amount.(c) To issue equity capital for Rs. 25 lakhs (face value of Rs. 10) and 16% non-convertible

debentures for the balance amount. In this case the company can issue shares at a

premium of Rs. 40 each.

Advice the management as to how the additional capital can be raised. Show workings.

Note: The management wants to maximize the earnings per share to maintain its goodwill. The

company is paying income-tax at 50%.

5. Paramount Ltd. wants to raise Rs. 100 lakhs for a diversification project. Current estimate ofearnings before interest and taxes (EBIT) from the new projects is Rs. 22 lakhs per annum. Cost

of debt will be 15% for amounts up to and including Rs. 40 lakhs, 16% for additional amounts up

to and including Rs. 50 lakhs and 18% for additional amounts above Rs. 50 lakhs. The equity

shares (face value Rs. 10) of the company have a current market value of Rs. 40. This is expectedto fall to Rs. 32 if debts exceeding Rs. 50 lakhs are raised. The following options are under

consideration of the company.

Option Equity Debt

I 50% 50%

II 60% 40%

III 40% 60%

Determine the earning per share (EPS) for each option and state which option the company should

exercise. Tax rate applicable to the company is 50%.


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6. A company needs Rs. 12,00,000 for the installation of a new factory which would yield an annualEBIT of Rs. 2,00,000. The company has the objective of maximizing the earnings per share. It is

considering the possibility of issuing equity shares plus raising a debt of Rs. 2,00,000, Rs.

6,00,000 or Rs. 10,00,000. The current market price per share is Rs. 40 which is expected to drop

to Rs. 25 per share if the market borrowings were to exceed Rs. 7,50,000. Cost of borrowings are

indicated as under:

Upto Rs. 2,50,000 10% p.a.

Between Rs. 2,50,001 to Rs. 6,25,000 14% p.a.

Between Rs. 6,25,001 to Rs. 10,00,000 16% p.a.

Assuming the tax rate to be 50%, work out the EPS and the scheme which would meet the objective of

the management.

7. The BCA Ltd. needs Rs. 5,00,000 for construction of a new plant. The following three financialplans are feasible:

(i) The company may issue 50,000 equity shares at Rs. 10 per share.(ii) The company may issue 25,000 equity shares at Rs. 10 per share and 2,500 debentures

of Rs. 100 denomination bearing 8% rate of dividend.

(iii) The company may issue 25,000 equity shares at Rs. 10 per share and 2,500 preferenceshares at Rs. 100 per share bearing 8% rate of dividend.

If the companys earnings before interest and taxes are Rs. 10,000, Rs. 20,000, Rs. 40,000, Rs. 60,000

and Rs. 1,00,000, what are the earnings per share under each of the three financial plans? Whichalternative would you recommend and why? Assume corporate tax rate to be 50%.

8. The Model Chemicals Ltd. requires Rs. 25,00,000 for a new plant. This plant is expected to yieldearnings before interest and taxes of Rs. 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 Rs. 2,50,000 or Rs. 10,00,000 or Rs. 15,00,000 and the

balance, in each case, by issuing equity shares. The companys share is currently selling at Rs.150, but is expected to decline to Rs. 125 in case the funds are borrowed in excess of Rs.

10,00,000. The funds can be borrowed at the rate of 10% upto Rs. 2,50,000, at 15% over Rs.

2,50,000 and upto Rs. 10,00,000 and at 20% over Rs. 10,00,000. The tax rate applicable to the

company is 50%. Which form of financing should the company choose?


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9. The existing capital structure of XYZ Ltd. is as follows:Rs.

Equity shares of Rs. 100 each 40,00,000

Retained earnings 10,00,000

9% Preference shares 25,00,000

7% Debentures 25,00,000

Company earns a return of 12% and the tax on income is 50%.

Company wants to raise Rs. 25,00,000 for its expansion project for which it is considering following

alternatives:

(i) Issue of 20,000 Equity shares at a premium of Rs. 25 per share; (ii) Issue of 10% preferenceshares; (iii) Issue of 9% Debentures.

(ii) Projected that the P/E ratios in the case of equity, preference and debenture financing 20,17and 16 respectively.

Which alternative would you consider to be the best. Give reasons for your choice.

10.KLM Ltd. has the following structure (Rs. Lakhs)Ordinary shares: 10 lakh Nos. @ Rs. 10 each 100

Reserves and surplus 40

10% debentures each of face value of Rs. 100 60

200

The company needs Rs. 50 lakhs to execute a new project which will raise its operating profit (EBIT) from

the current level of Rs. 40 lakhs to Rs. 55 lakhs. It is considering the following options:

(i) Issue equity shares at a premium of Rs. 15 each for the entire amount.(ii) Issue 12% debentures for Rs. 50 lakhs required additionally.(iii) Issue equity shares for Rs. 25 lakhs at a premium of Rs. 20 per share and issue 12%

debentures for the balance amount.

The companys tax rate is 40%. Evaluate the three options and advise the company.


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problems in capital structuring

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