School of Business

Management

& Liberal Arts

(MASTER OF BUSINESS ADMINISTRATION)

Assignment of Financial Management

Submitted to: Prof. Narinder Verma

Session 2018-2019

Submitted by : Pratiksha Kandari

Regesteration No – 1871401097
MBA Quard – 4
Submission Date : 21/5/2019
Q4. ABC Company has currently an all equity capital structure consisting of 15000 equity
shares of Rs. 100 each. The management is planning to raise another Rs. 25 lakhs to finance a
major programme of expansion and is considering three alternative methods of financing:
1. To issue 25000 equity shares of Rs. 100 each.
2. To issue 25000 8% debentures of Rs. 100 each.
3. To issue 25000 8% Preference Shares of Rs. 100 each. The company’s expected earnings
before interest and taxes will be Rs. 8 lakhs. Assuming a corporate tax rate of 50 percent,
determine the earnings per share (EPS) in each alternative and comment which alternative is
best and why?

SOLUTION:-
Particulars Equity Debt Preference
financing financing shares
financing
Earningbefore interest and tax(EBIT) 8.00 8.00 8.00
Less interest - 2.00 -
Earnings after interest but before tax 8.00 6.00 8.00
Less tax 50% 4.00 3.00 4.00
Earning after tax(EAT) 4.00 3.00 4.00
Less preference dividend - - 2.00
Earning available to equity shareholder 4.00 3.00 2.00
Number of equity shares 40000 15000 15000
Earning per share(EPS) Rs 10 Rs 20 Rs 13.33

As the earnings per share are highest in alternative II, i.e., debt financing, the company
should issue 25,000 8% debentures of Rs. 100 each. It will double the earnings of the equity
shareholders without loss of any control over the company.

Q5. A ltd. company has equity share capital of Rs. 500000 divided into shares of Rs. 100
each. It wishes to raise further Rs. 300000 for expansion cum modernization plans. The
company plans the following financing schemes:
1. All common stock
2. Rs. One lakh in common stock and Rs. Two lakhs in debt @ 10% p.a.
3. All debts at 10% p.a.
4. Rs. One lakh in common stock and Rs. Two lakh in preference capital with the rate of
dividend at 8%. The company’s existing earnings before interest and tax (EBIT) are Rs.
150000. The corporate rate of tax is 50%. Determine the earnings per share (EPS) in each
plan and comment on the implications of financial leverage.
SOLUTION:-

Particulars Plan I PLAN II PLAN III PLAN IV

Earning before interest and 1,50,000 1,50,000 1,50,000 1,50,000
tax(EBIT)
Less interest - 20,000 30,000 -
Earnings after interest but 1,50,000 1,30,000 1,20,000 1,50,000
before tax
Less tax 50% 75,000 65,000 60,000 75,000
Earning after tax(EAT) 75,000 65,000 60,000 75,000
Less preference dividend - - - 16000
Earning available to equity 75,000 65,000 60,000 59,000
shareholder
Number of common shares 8000 6000 5000 6000
Earning per share(EPS) RS 9.375 RS 10.83 RS 12 RS 9.83

In the four plans of fresh financing, Plan III is the most leveraged of all. In this case,
additional financing is done by raising loans @ 10% interest. Plan II has fresh capital stock of
Rs. One lakh while Rs. two lakhs are raised from loans. Plan IV does not have fresh loans but
preference capital has been raised for Rs. two lakhs.

Q6. A company expects a net operating income of Rs. 80000. It has Rs. 200000, 8%
debentures. The equity capitalization rate of the company is 10%. Calculate the value of the
firm and overall capitalization rate according to the Net Income Approach (ignoring income
tax). If the debenture debt is increased to Rs. 300000, what shall be the value of the firm and
the overall capitalization rate?

SOLUTION:-
Particulars Plan I
Earning before interest and 80,000
tax(EBIT)
Less interest 16000
Earnings after interest but 64,000
before tax
Equity capitalization rate 10%
Marketvalue if equity 6,40,000
 Value of debt 200000
Value of firm 8,40,000
Overall cost of capital 9.52%

If debt is raised to Rs 300000

Particulars Plan I
Earning before interest and 80,000
tax(EBIT)
Less interest 24,000
Earnings after interest but 56,000
before tax
Equity capitalization rate 10%
Market value if equity 5,60,000
Value of debt 300000
Value of firm 8,60,000
Overall cost of capital 9.30%

With increase in debt financial value of firm increased and overall cost of capital has
decreased

Q7. A company expects a net operating income of Rs. 100000. It has Rs. 500000, 6%
debentures. The overall capitalization rate is 10%. Calculate the value of the firm and the
equity capitalization rate (cost of equity) according to net operating income approach. If the
debenture debt is increased to Rs.750000, what will be the effect on the value of the firm and
the equity capitalization rate?

SOLUTION:-
EBIT= 100000
Cost of capital-10%
Market value of the firm= 1000000
(-) Market value of debt= 500000
Market value of equity= 500000
Equity capitalization rate= EBIT- I/V-D
=100000-30000/1000000-500000 *100
=700000/500000 *100 =14%
If debt is increased to 750000, the value of the firm remains unchanged and equity
capitalization rate will be
K0= EBIT-I/V-D =100000-45000/1000000-750000 *100
=55000/250000 *100
=22%

Q8. Compute the market value of the firm, value of shares and the average cost of capital
from the following information:
Net operating income Rs. 200000
Total Investment Rs. 1000000
Equity Capitalization Rate:
1. If the firm uses no debt : 10%
2. If the firm uses Rs. 400000 debentures at 5% pa : 11%
3. If the firm uses Rs. 600000 debentures at 6%pa : 13%

SOLUTION:-
Particulars No debt 400000 600000
5% debt 6% debt
Earning before interest and 200000 1,50,000 1,50,000
tax(EBIT)
Less interest - 20,000 36000
Earnings 200000 180000 164000
Equity capitalization rate 10% 11% 13%
Market value of equity 200000 1636363 1261538
Market value of debt - 400000 600000
Market value of firm 200000 2036363 1861538
Average cost of capital 200000/2000000 200000/203636 200000/1861538
*100 3 *100 *100
=10% =9.8% =10.7%

Q9. A company has earnings before interest and taxes of Rs. 100000. It expects a return on its
investment at a rate of 12.5%. You are required to find out the total value of the firm
according to the MM theory.

SOLUTION:-
According to MM theory , total value of the firm remains constant. It does not change with
change in capital structure.
Value of the firm, V= EBIT/Ko
=100000/(12.5/100)
=100000*100/12.5
=Rs 800000
 Q10:The existing capital
structure of Agile Ltd., is as
given below:

Equity Shares of Rs 100 Rs. 40,00,000

each
Retained Earnings Rs. 10,00,000
9% Preference Shares Rs. 25,00,000
7% Debentures Rs. 25,00,000
The company earns a return of 12% on its capital and 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% preference shares.
iii. Issue of 9% debentures.

Projected that the P/E ratios in the case of equity, preference and debenture financing would
be 20, 17 and 16 respectively.
Which alternative would you consider to be the best on the basis of:
a) Earnings per share (EPS).
b) Expected market price per share (MPS).

SOLUTION:-
Particulars I II III
Earning before interest and 15,00,000 15,00,000 15,00,000
tax(EBIT)
Less interest 7% 175000 175000 175000
Less interest 9% - - 250000
Earnings after interest but 1325000 1325000 1100000
before tax
Less tax 50% 662500 662500 550000
Less preference dividend 9% 225000 225000 225000
437500 437500 325000
Less preference dividend 10% - 250000 -
Earning available to equity 437500 187500 325000
shareholder
Number of common shares 60000 40000 40000
Earning ratio 20 17 16
M.P RS 145.8 RS 79.68 RS 130