Ch. 02 Types of Financing

2
TYPES OF FINANCING
Question 1
Discuss briefly the impact of taxation on Corporate Financing. (8
marks) (November, 1996)
Answer
Impact of Taxation on Corporate Financing: Tax is levied on the
profits of the company. Tax is also levied on the dividends distributed
to shareholders. However, such dividends are exempt in their hands.
Thus, the corporate entity suffers tax twice in a sense. This pushes
the cost of equity capital. On the other hand interest paid on the debt
capital is a deductible expenditure and hence company does not pay
tax on interest on debt capital. This reduces the cost of debts. Debt
is a less costly source of funds and if the finance manager prudently
mixes debt and equity, the weighted average cost of capital will get
greatly reduced.
Depreciation is not an outgo in cash but it is deductible in computing
the income subject to tax. There will be saving in tax on depreciation
and such savings could be profitably employed. Thus, both interest
and depreciation provide tax shield and have a tendency to increase
EPS. Further the unabsorbed depreciation can be carried forward
indefinitely and this will be helpful for loss making concerns which
start earning profits in future. The depreciation loss of one company
can be carried forward for set off in another companys profits in the
case of amalgamations in specified circumstances and such a
provision will help growth of companies and rehabilitation of sick
units. The finance manager of amalgamating company will bear this
benefit for the tax shield it carries in planning the activities.
Thus, the impact of tax will be felt in cost of capital, earnings per
share and the cash in flows which are relevant for capital budgeting
Management Accounting and Financial Analysis
and in planning the capital structure.
Tax considerations are important as they affect the liquidity of the
concerns. They are2 relevant in deciding the leasing of the assets,
transactions of sale and lease back, and also in floating joint venture
in foreign countries where tax rates and concessions may be
advantageous. Tax implications will be felt in choosing the size and
nature of industry and in its location as the tax laws give fillip to small
units producing certain products and incentives are given for
backward areas. Tax considerations in these matters are relevant for
purposes of preserving and protecting internal funds.
110
Types of Financing
Question 2
The Balance Sheet of Smart Ltd. as on March 31, 1997 is as follows:
(Figures in lakhs of rupees)
Liabilities Assets
Share Capital 200 Fixed Assets 500
Reserves 140 Inventories 300
Long term Loans 360 Receivables 240
Short term Loans 200 Cash and Bank 60
Payables 120
Provisions 80 _____
1,100 1,100
Sales for the year were 600 lakhs. For the year ending on March 31,
1998 sales are expected to increase by 20%. The profit margin and
dividend pay out ratio are expected to be 4% and 50% respectively.
You are required to:
(i) Quantify the amount of external funds required.
(ii) Determine the mode of raising the funds given the following
parameters:
(a) Current ratio should at least be 1.33.
(b) Ratio of fixed assets to long term loans should be 1.5.
(c) Long term debt to equity ratio should not exceed 1.05.
(iii) The funds are to be raised in the order of short term bank
borrowings, long term loans and equities.
(14 marks) (May 1997)
Answer
External funds requirement (EFR) is given by the following formula:
(i) d) - (1 ms - S
S
L
-
S
A
EFR
1

,
_
Where EFR External funds requirement

A = Total assets
S = Previous sales
L = Payables and provisions
m = Profit Margin
s
1
= Projected sales for the next year
111
d = Dividend payout ratio
S = Expected increase in sales
By substituting the figures, we get the following:
[ ] 0.5 720 0.04 - 20 1
600
200
-
600
1,100
EFR
,
_
= 1.5 120 14.4

= Rs. 180 14.4
= Rs. 165.6 lakhs
(ii) Mode of raising the funds:
Short term borrowings
(a) Current ratio should be 1.33
[ ] borrowings bank term short is STBB Where STBB 1.2 200
1.2 600
1.33
+
STBB 240
20 7

1
1.33
+
(By substituting and solving the equation)

STBB will be 301.35
Existing loans 200.00
Additional borrowings 101.35
(b) Long term debt:
Ratio of fixed assets to long term loans = 1.5
1.5
LT
1.2 500
1.5 LT = Rs. 600

LT = Rs. 400
Loans already
existing
= Rs. 360
Additional = 40
(c)
Equity:
External Funds 165.60
Less: Additional bank
borrowings
101.35
112
Types of Financing
Additional long term
loans
40.00
141.35
Balance additional equity 24.25
Proof: Debt equity ratio should not exceed 1.05
1.02
168 224.25
400
+
Hence, the condition is satisfied.
Note:
(i) Long term debt = 360 + 40 = 400
(ii) Equity share capital = 200 + 24.25 = 224.25
(iii) Reserves will also increase by 20% = 140 1.2 = 168
(iii) The funds are to be raised in the order of
STBB 101.53
Long term loans 40.00
Equity 24.25
Total 165.60
Question 3
Promoters contribution is one of the principal means of financing
the project Discuss.
(10 marks) (May 1997)
Answer
The promoter is required to provide funds irrespective of whether the
project is an existing one or a new venture.
Promoters contribution consists of:
(a) Share capital to be subscribed by the promoters in the form of
equity share capital and/or preference share capital.
(b) Equity shares issued as rights shares to the existing shareholders.
(c) Convertible debentures issued as rights to existing
shareholders.
(d) unsecured loans.
(e) Seed capital assistance.
(f) Venture capital.
113
(g) Internal cash accruals.
In the case of projects established in joint or assisted sector, the
contribution of state industrial investment corporation towards share
capital is also considered as part of promoters total contribution.
The Government of India has classified the locations for establishing
industrial units into three categories A, B and C such as:
Category A As no industrial district
Category B as districts where industrial activity has started
Category C as districts where industrial activity has gained
sufficient ground
Generally promoters are expected to contribute about 22.5% of cost
of the project in the case of listed and unlisted companies. However,
the promoters contribution can be reduced for projects located in the
notified backward districts/areas i.e. category A areas. Similarly, it
is kept low for projects promoted by technocrat entrepreneurs. In
case of projects set up by existing companies, the extent of
promoters contribution is determined keeping in view the nature and
location of the project, background of the promoters and the existing
cash accruals and as per SEBIs guidelines for disclosure and
investors protection. Promoters contribution is also reduced below
the normal requirements to encourage non-MRTP (Now Competition
Act, 2002) companies to enter in the field of certain industries. At
present the minimum requirement of promoters contributions
stipulated by All India Financial Institutions is as under:
Category of the project Promoters
contribution as
percentage of
project cost
1. Normal norms 22.5%
2. Concessional norms
(i) New projects set up in notified
backward districts (No Industry
District) falling under Category A
backward areas.
17.5%
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Types of Financing
(ii
)
New projects set up in notified
backward districts falling under
Category A backward areas (No
Industry Districts) provided the cost
of the project is above Rs. 25 crores
and its is set up by non-MRTP
companies.
(Now as per provisions Competition
Act, 2002.)
12.5%
(ii
i)
Projects set up in notified backward
districts/areas falling under
Category B
17.5%
(i
v)
Projects set up in notified backward
districts/areas falling under
Category C
20.0%
(v
)
Projects sponsored by technician
entrepreneurs
17.5%
Promoters contribution indicates the extent of their involvement in a
project in terms of their own financial stake. In case the promotes are
unable to raise funds to meet the norms of financial institutions, they
can avail the benefit of seed capital assistance under any of the
schemes of RDC or IDBI or RCTC etc. The investments made by
recognized mutual funds are also considered as promoters
contribution provided the investment is covered by non-disposal
undertaking or buy-back clause.
Among different means of finance such as capital incentives, deferred
payment guarantees, lease finance/hire purchasing, term loans from
financial institutions in the form of rupee loans and foreign currency
loans etc., promoters contribution is one of the most important source
of finance.
Question 4
TSL Ltd. a highly profitable and tax paying company is planning to
expand its present capacity by 100%. The estimated cost of the
project is Rs. 1,000 lakhs out of which Rs. 500 lakhs is to be met out
of loan funds. The company has received two offers from their
bankers:
Option 1 Option 2
Value of loan Rs. 500 lakhs US $ 14 lakhs equal to Rs.
115
500 lakhs
Interest 15% payable yearly 6% payable (fixed) yearly
in US $
Period 5 years 5 years
Repayment (In 5 instalments.
First instalment is
payable 1 year after
draw down)
Other expenses
(to be treated as
revenue
expenditure)
1% of the value of
the loan
1% at US $ = Rs. 36
(Average)
Future exchange
rate

End of 1 year 1US $ = Rs.
38 thereafter to increase
by Rs. 2 per annum
The company is liable to pay Income-tax at 35% and eligible for 25%
depreciation on W.D. value. You may assume that at the end of 5th
year the company will be able to claim balance in WDV for tax
purposes. The company follows Accounting Standard AS-11 for
accounting changes in Foreign Exchange Rate.
(1) Compare the total outflow of cash under the above options.
(2) Using discounted cash flow techniques, evaluate the above offers.
(3) Is there any risk, which the company should take care of?
(4) In case TSL has large volume of exports would your advise be
different.
The following discounting table may be adopted:
Years: 0 1 2 3 4 5
Discounting
Factor:
1 0.921 0.848 0.781 0.720 0.663
(20 marks) (November 1997)
116
Types of Financing
Answer
Option I
(Rs. in lakhs)
Years: Repaym
ent of
Principal
Interest
at 15%
Other
Expens
es
Tax
saving
Net
Outflow
0

5.00 1.75 3.25
1 100 75 26.25 148.75
2 100 60

21.00 139.00
3 100 45 15.75 129.25
4 100 30

10.50 119.50
5 100 15 5.25 109.75
Total Outflows 500 + 225 +5.00
80.50
=
649.50
Option II
Exchan
ge Rate
Year Repayme
nt of
principal
Intere
st at
Other
Charge
s
Total
Amou
nt
Repayme
nt of
principal
Balanc
e being
Premiu
m
Intere
st
Other
Charge
s
Total
Payme
nt
Tax
Saving
s
Net
Outflo
w
US $ Rs. in lakhs
36 0 0.140 0.140 5.04 5.04 1.764 3.276
38 1 2.8 0.840 3.640 100.00 6.4 31.920 138.32 11.732 126.58
8
40 2 2.8 0.672 3.472 100.00 12.0 26.880 138.88 10.878 128.00
2
42 3 2.8 0.504 3.304 100.00 17.6 21.168 138.76
8
10.048 128.72
0
44 4 2.8 0.336 3.136 100.00 23.2 14.784 137.98
4
9.184 128.80
0
46 5 2.8 0.168 2.968 100.00 28.8 7.728 136.52
8
24.814 111.71
4
14.0 2.520 0.140 16.660 500.00 88.0 102.48 5.04 695.52
0
68.420 627.10
0
As per AS 11, the premium paid on exchange rate difference, on loans
acquired for the purpose of capital expenditure, should be capitalized.
117
The same is applicable under the Indian Income-tax Act for tax
calculations also.
Tax savings on Premium capitalization
(Rs. in lakhs)
Year Openin
g Value
Premiu
m
Total Deprecia
tion on
premium
at 25%
Tax
saving
at
35%
Closing
WDV
1

6.40 6.40 1.60 0.56 4.80
2 4.80 12.00 16.80 4.20 1.47 12.60
3 12.60 17.60 30.20 7.55 2.64 22.65
4 22.65 23.20 45.85 11.46 4.01 34.39
5 34.39 28.80 63.19* 63.19 22.11 Nil
*Assumed that full benefit will be claimed for tax purposes.
Tax savings on interest, other charges and Premium.
(Rs. in lakhs)
Year Amount of
interest and
other charges
Tax
savings
Tax
saving
on
premium
Total Tax
savings
0 5.040 1.764 1.764
1 31.920 11.172 0.560 11.732
2 26.880 9.408 1.470 10.878
3 21.168 7.408 2.640 10.048
4 14.784 5.174 4.010 9.184
5 7.728 2.704 22.110 24.814
(2) Discounted Cash Flow: Option I
(Rs. in lakhs)
Year Net outflow Discounting
factor
Discounted
value
0 03.250 1.000 3.25
1 148.750 0.921 136.99
2 139.000 0.848 117.87
118
Types of Financing
3 129.250 0.781 100.94
4 119.500 0.720 86.04
5 109.750 0.663 72.76
517.85
Discounted cash flow: Option II
(Rs. in lakhs)
Year Gross
outflow
Total tax
saving
Net
outflow
Discount
ed factor
Discount
ed value
0 5.040 1.764 3.276

3.276
1 138.320 11.732 126.588 0.921 116.587
2 138.880 10.878 128.002 0.848 108.545
3 138.768 10.048 128.720 0.781 100.530
4 137.984 9.184 128.80
0
0.720 92.736
5 136.528 24.814 111.714 0.663 74.066
495.740
(3) The absolute and discounted value of option II seems to be better
than option I. However, the company has to be careful about
future exchange rate. The rate indicated is more by rule of thumb
than based on any scientific approach. The company should
cover the foreign exchange rate and then work out the value.
(4) In case the company has good volume of exports, then it may
help the company to hedge the future payments with outflow. In
that case the company may take a lenient view of the possible
exchange risk.
Question 5
X Ltd., a widely held company is considering a major expansion of its
production facilities and the following alternatives are available:
Alternative (Rs.in lakhs)
A B C
Share Capital 50 20 10
14% Debentures 20 15
Loan from a Financial
Institution @ 18%
119
p.a. Rate of Interest
10 25
Expected rate of return before tax is 25%. The rate of dividend of the
company is not less than 20%. The company at present has low debt.
Corporate taxation 50%.
Which of the alternatives you would choose? (8
Answer
(Rs.in lakhs)
A B C
Return on Rs. 50 lakhs @ 25% 12.50 12.50 12.50
Less: Interest on Debentures 2.80 2.10
Interest on loan

1.80 4.50
Taxable profit 12.50 7.90 5.90
Income tax 50% 6.25 3.95 2.95
Profit after tax available to
shareholders
6.25 3.95 2.95
Rate of return on share capital 12.5% 19.75% 29.5%
From shareholders point of view alternative C (highest) is to be
chosen.
Question 6
Write short notes on
(a) Bridge Finance.
(b) Call and put option with reference to debentures. (5 + 5 = 10
Answer
(a) Bridge Finance: Bridge finance refers, normally, to loans
taken by a business, usually from commercial banks for a short
period, pending disbursement of term loans by financial
institutions, normally it takes time for the financial institution to
finalise procedures of creation of security, tie-up participation with
other institutions etc. even though a positive appraisal of the
project has been made. However, once the loans are approved in
principle, firms, in order not to lose further time in starting their
projects arrange for bridge finance. Such temporary loan is
120
Types of Financing
normally repaid out of the proceeds of the principal term loans. It
is secured by hypothecation of moveable assets, personal
guarantees and demand promissory notes. Generally rate of
interest on bridge finance is higher as compared with that on term
loans.
(b) Call and put option with reference to debentures:
(1) A debenture is an instrument for a fixed period of time mostly
at fixed rate of interest.
(2) Now a days the rate of interest varies significantly.
(3) With inflow of enormous foreign funds this has assumed
greater significance.
(4) A call option gives a liberty to the issuer of the debenture to
pay back the amount earlier to the redemption date at a pre-
determined price (strike price) within the specified period. In
case the option is not exercised the debenture continues.
(5) On the other hand, a put option means, a right to investors to
demand back the money earlier to the redemption date at a
pre-determined price (strike price) within the specified period.
(6) The debenture holder can get back the money and invest it
elsewhere.
(7) These kinds of options are necessary to make the instrument
investor friendly and to ensure liquidity in debentures market.
121
Question 7
The following figures are made available to you:
Rs.
Net profits for the year 18,00,00
0
Less: Interest on secured debentures at 15% p.a.
(debentures were issued 3 months after the
commencement of the year)
1,12,50
0
16,87,50
0
Less: Income-tax at 35% and dividend distribution tax 8,43,75
0
Profit after tax 8,43,75
0
Number of equity shares (Rs. 10 each) 1,00,000
Market quotation of equity share Rs.
109.70
The company has accumulated revenue reserves of Rs. 12 lakhs. The
company is examining a project calling for an investment obligation
of Rs. 10 lakhs. This investment is expected to earn the same rate of
return as funds already employed.
You are informed that a debt equity ratio (Debt divided by debt plus
equity) higher than 60% will cause the price earning ratio to come
down by 25% and the interest rate on additional borrowals will cost
company 300 basis points more than on their current borrowal on
secured debentures.
You are required to advise the company on the probable price of the
equity share, if
(a) the additional investment were to be raised by way of loans; or
(b) the additional investment were to be raised by way of equity.
(10 marks) (May 1998)
Answer
Working Note:
Present earning/share: Rs.
Profit before taxes 16,87,5
122
Types of Financing
00
Less: Tax at 35% 5,90,6
25
75
No. of equity shares 1,00,0
00
1,00,000
10,96,875 Rs.
E.P.S.
E.P.S. = Rs. 10.97
Market price Rs. 109.70
10
10.97 Rs.
109.70 Rs.
P/E Hence,
(a) Probable price/share, if the additional investment were to
be raised by way of loans
Present capital employed: Rs.
Equity 10,00,000
Debenture (Long term) 10,00,000
Revenue reserves 12,00,000 Rs.
32,00,000
Pre-interest and pre-tax profits given Rs. 18 lakhs
56.25%
lakhs 32 Rs.
100 lakhs 18 Rs.
EBIT return of Rate
Debt equity ratio, if Rs. 10 lakhs (additional investment) were to

be borrowed
(Debt Rs. 20 lakhs and equity Rs. 22 lakhs), will be
47.6%
lakhs 42 Rs.
100 lakhs 20 Rs.

since, the debt equity ratio will not exceed 60% P/E will remain
same.
If Rs. 10 lakhs is to be borrowed, the earning will be as under:
Rs. Rs.
123
Return of 56.25% on Rs. 42 lakhs 23,62,50
0
Less: Interest at 15% on existing Rs. 10 lakhs
debentures
1,50,00
0
Interest on fresh borrowed amount of Rs. 10
lakhs at 18%
1,80,00
0
3,30,00
0
Profit after interest before tax 20,32,50
0
Less: Tax at 35% 7,11,3
75
5
13.21 Rs.
1,00,000 Rs.
13,21,125 Rs.
E.P.S.
Probable price of equity share = Rs. 13.21 10
(Refer to working note)
= Rs. 132.10
(b) Probable price/share, if additional investment were to be
raised by way of equity.
If Rs. 10 lakhs were to be raised by way of equity shares at
market rates. The existing market price of Rs. 109.70 may come
down a little and may possibly settle at Rs. 100. Hence, new
equity shares to be raised will be
Rs. 10,00,000/Rs. 100 = 10,000 shares.
If Rs. 10 lakhs is to be raised by way of equity shares, the earning
will be as under:
Rs.
Profit before interest and tax 23,62,5
00
Less: Interest on debentures 1,50,0
00
Profit after interest before tax 22,12,5
00
Less: Tax @ 35% 7,74,3
124
Types of Financing
75
25
0
13.07 Rs.
1,10,000
14,38,125 Rs.
E.P.S.
,
_
Probable price of equity share = Rs. 13.07 10

(Refer to working note)
= Rs. 130.70
The suggested solution will be to issue fresh debentures to
finance expansion.
Question 8
The following is the Balance Sheet as at 31st March, 1998 of S Co.
Ltd.
Rs. Rs.
Share Capital:
10,000 equity shares of Rs. 100 each fully paid
up
10,00,0
00
25,000 11% cum preference shares of Rs. 10
each fully paid up
2,50,0
00
12,50,
000
Reserves and surplus 25,00,0
00
Secured loans 20,00,0
00
Unsecured loans 12,00,0
00
Trade creditors 18,00,0
00
Outstanding expenses 7,50,0
00
95,00,0
00
Represented by
Fixed assets 55,00,0
125
00
Current assets 37,00,0
00
Advances and deposits 3,00,0
00
95,00,0
00
The company plans to manufacture a new product in line with its
current production, the capital cost of which is estimated to be Rs. 25
lakhs. The company desires to finance the new project to the extent
of Rs. 16 lakhs by issue of equity shares at a premium of Rs. 100 per
share and the balance to be raised from internal sources.
Additional informations made available to you are:
(a) Rate of dividends declared in the past five years i.e. year ended
31st March, 1998, 31st March, 1997, 31st March, 1996, 31st
March, 1995 and 31st March, 1994 were 24%, 24%, 20%, 20%
and 18% respectively.
(b) Normal earning capacity (net of tax) of the business is 10%.
(c) Turnover in the last three years was Rs. 80 lakhs (31.3.1998), Rs.
60 lakhs (31.3.1997) and Rs. 50 lakhs (31.3.1996).
(d) Anticipated additional sales from the new project Rs. 30 lakhs
annually.
(e) Net profit before tax from the existing business which was 10% in
the last three years is expected to increase to 12% on account of
new product sales.
(f) Income-tax rate is 35%.
(g) The trend of market price of the equity share of the company,
quoted on the Stock Exchange was:
Year High Low
Rs. Rs.
1997-98 300 190
1996-97 250 180
1995-96 240 180
You are required to examine whether the companys proposal is
justified. Do you have any suggestions to offer in this regard? All
workings must form part of your answer.
(20 marks) (November, 1998)
126
Types of Financing
Answer
(a) Earning per share for the year ended 31st March, 1998 of S
Co. Ltd.
Rs.
Turnover 80,00,000
Net Profit (10% of Rs. 80,00,000) 8,00,000
Less: Income tax @ 35% 2,80,000
Less: Preference dividend (11% of Rs. 2,50,000) 27,500
Profit available for equity shareholders: (A) 4,92,500
Number of equity shares: (B) 10,000
Earning per share: (A)/(B) Rs. 49.25
(b) Expected earning per share after the manufacture of
new product
(New project financed to the extent of Rs. 16 lakhs by issue of
equity shares)
Rs.
Anticipated turnover 1,10,00,0
00
(Refer to Working Note 1)
Net Profit (12% of Rs. 1,10,00,000) 13,20,00
0
0
Less: Preference dividend (11% of Rs.
2,50,000)
27,500
Profit available for equity shareholders: (A) 8,30,500
Number of equity shares: (B) 18,000
Expected earning per share: (A)/(B) Rs. 46.14
127
(c) Price earning ratio for the year ended as on 31st March
1998 of S Co. Ltd.
Average price per share (300 + 190)/2 : (A) Rs. 245
Earning per share : (B) Rs.
49.25
(Refer to (a) above)
Price earning ratio : (A)/(B)
4.974 or
5 times (rounded off)
Justification: On the basis of (a), (b) and (c) above.
1. There will be decline in market value of share after the new
project financed by issue of equity shares and internal sources
become operational. Expected market value of share will be
E.P.S. P/E ratio i.e. Rs. 46.14 5 = Rs. 230.70.
2. The stock exchange quotation reveal that the company share
has been quoted at below book value of Rs. 350 per share
(Refer to working note 3). The proposed financing pattern is
not going to increase E.P.S. It will on the other hand decline
marginally. Thus, the existing equity shareholders will not be
benefited much from the new issue. However, in case shares
are offered to the outsiders, they will gain since a share with
intrinsic (book) value of Rs. 350 is being offered at a price of
Rs. 200.
Thus, the companys proposal to finance the new project to
the extent of Rs. 16 lakhs by issue of equity shares at
premium of Rs. 100 per share and balance from internal
sources is not justified and the company should, therefore,
reconsider the scheme of financing the project by a new
equity issue.
The S Co. Ltd. present debt equity ratio is 0.53 (Refer to
working note 5). As per the prudential norm, the debt equity
ratio shall not exceed 2 : 1. Accordingly, the company seems
to possess debt capacity/leverage. It can raise the required
funds say, by issue of debentures @ 12% to 13% interest.
Expected earnings per share after the manufacture of new
product
(New project financed to the extent of 16 lakhs by issue of
debentures @ 12%)
128
Types of Financing
Rs.
Anticipated turnover 1,10,00,000
Expected profit on turnover 13,20,000
Less: Interest on debentures (12% on Rs. 16
laklhs)
1,92,000
Net Profit before tax 11,28,000
Net profit after tax 7,33,200
Less: Preference dividends 27,500
Profit available for equity shareholders 7,05,700
No. of equity shares 10,000
Earning per share Rs. 70.57
Justification:
1. There will be increase in the market value of share after the
new project financed by issue of debentures and internal
accruals become operational. Expected market value of share
will be E.P.S. P/E ratio i.e. Rs. 70.57 5 times = Rs. 352.85.
2. The E.P.S. will increase to Rs. 70.57.
3. The debt equity ratio of the S Co. Ltd. will be 0.96 (Refer to
working note 6) after the new project is financed by issue of
debentures. The ratio 0.96 is within the prudential norm of 2 :
1.
Suggestion: On the basis of the above workings, it is suggested
that it will be better if the company raise the funds, required for
financing the new project, by issuing debentures instead of equity
shares. This is because the market price per share and earning
per share is higher in case of debenture financing without undue
risk.
Working Notes:
Rs.
1. Anticipated turnover
Present turnover 80,00,00
0
129
Add: Anticipated additional sales of new
product
30,00,
000
1,10,00,
000
2. Number of new equity shares to be
issued
Funds required by issue of equity
shares : (A)
Rs. 16,00,000
Funds raised by issue of 1 new equity
share: (B)
Rs. 200
No. of new equity share to be issued:
(A)/(B)
8,000
Rs.
3. Book value of one equity share
10,000 equity shares of Rs. 100 each fully
paid up
10,00,00
0
Add: Reserves and surplus 25,00,
000
35,00,00
0
Book value of one equity share 350
Alternatively Rs.
0
0
Advances and deposits 3,00,00
0
95,00,00
0
Less: Preference share capital 2,50,000
Secured loans 20,00,00
0
130
Types of Financing
Unsecured loans 12,00,00
0
Trade creditors 18,00,00
0
Outstanding expenses 7,50,00
0
60,00,00
0
35,00,00
0
Book value of one share 350
4. Present debt equity ratio

surplus and Reserves Capital Share
loans Secured

+
lakhs 37.50 Rs.

lakhs 20 Rs.

= 0.53
5. Expected debt equity ratio
surplus and Reserves Capital Share
debentures Proposed loans Secured

+
+
lakhs 37.50 Rs.

lakhs 16 Rs. lakhs 20 Rs.

+
= 0.96
Question 9
The Modern Chemicals ltd. requires Rs. 25,00,000 for a new plant.
This plant is expected to yield earnings 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 projectby 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. 2,50,00 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 be the
131
company choose? (7 marks)
(November, 1999)
132
Types of Financing
Answer
Calculation of Earning per share for three alternatives to
finance the project
Alternatives
I II III
Particulars
To raise debt
of Rs.
2,50,000
To raise debt
of Rs.
10,00,000
To raise debt
of Rs.
15,00,000
and equity of
Rs.
22,50,000
and equity of
Rs.
15,00,000
and equity of
Rs.
10,00,000
Rs. Rs. Rs.
Earnings before
interest and tax
5,00,000 5,00,000 5,00,000
Less: Interest on debt 25,000 1,37,500 2,37,500
at the rate of (10% on Rs.
2,50,000)
(10% on Rs.
2,50,000)
(10% on Rs.
2,50,000)
(15% on Rs.
2,50,000)
(15% on Rs.
7,50,000)
________________ ________________
_
(20% on Rs.
5,00,000)
Earning before tax 4,75,000 3,62,500 2,62,500
Less: Tax @ 50% 2,37,500 1,81,250 1,31,250
Earnings after tax: (A) 2,37,500 1,81,250 1,31,250
Number of shares: (B) 15,000 10,000 8,000
(Refer to working
note)
Earning per share:
(A) / (B)
15.833 18.125 16.406
Decision: The earning per share is higher in alternative II i.e. if the
company finance the project by raising debt of Rs. 10,00,000 and
issue equity shares of Rs. 15,00,000. Therefore the company should
choose this alternative to finance the project.
Working Note:
Alternatives
133
I II III
Equity financing : (A) Rs. 22,50,000 Rs. 15,00,000 Rs. 10,00,000
Market price per share:
(B)
Rs. 150 Rs. 150 Rs. 125
Number of equity
shares : (A)/(B)
15,000 10,000 8,000
Question 10
The following is the capital structure of Simons Company Ltd. as on
31.12.1998:
Rs.
Equity shares: 10,000 shares (of Rs. 100
each)
10,00,000
10% Preference Shares (of Rs. 100 each) 4,00,000
12% Debentures 6,00,000
20,00,000
The market price of the companys share is Rs. 110 and it is expected
that a dividend of Rs. 10 per share would be declared for the year
1998. The dividend growth rate is 6%:
(i) If the company is in the 50% tax bracket, compute the weighted
average cost of capital.
(ii) Assuming that in order to finance an expansion plan, the
company intends to borrow a fund of Rs. 10 lakh bearing 14% rate
of interest, what will be the companys revised weighted average
cost of capital? This financing decision is expected to increase
dividend from Rs. 10 to Rs. 12 per share. However, the market
price of equity share is expected to decline from Rs. 110 to Rs.
105 per share. (10 marks) (November, 1999)
Answer
(i) Computation of the weighted average cost of
capital
Source of finance Proportion After tax cost
(%) (1-tax rate
i.e. 50%)
Weighted
average cost
of capital (%)
(a) (b) (c)
(d)= (b) (c)
Equity share 0.5 15.09 7.54
134
Types of Financing
(Refer to working note 1)
10% Preference share 0.2 10.00 2.00
12% Debentures 0.3 6.00 1.80
Weighted average cost
of capital
11.34
135
(ii) Computation of Revised weighted average
cost of capital
Source of finance Proportion After tax cost
(%) (1-tax rate
i.e. 50%)
Weighted
average cost
of capital (%)
(a) (b) (c)
(d)= (b) (c)
Equity share 0.333 17.42 5.80
10% Preference share 0.133 10.00 1.33
12% Debentures 0.200 6.00 1.20
14% Loan 0.333 7.00 2.33
Revised weighted average cost of
capital
10.66
Working Notes:
(1) Cost of equity shares (K
e
)
rate Growth
share per price Market
share per Dividend
K
e
+
0.06
110
10
+
= 0.1509 or 15.09%
(2) Revised cost of equity shares (K
e
)
0.06
105
12
K Revised
e
+
= 0.1742 or 17.42%
Question 11
Harbour Company, is a medium-sized producer of chemicals and vinyl
coatings used in a variety of industrial processes.
Last year, the company recorded over Rs. 1,500 lakhs in sales,
showed net income after tax of Rs. 250 lakhs and concluded a very
successful year. For the year coming up, the firm expects a 10 per
cent improvement in its sales and operating income figures. Other
relevant details Total assets Rs. 2,200 lakhs, Debt Asset Ratio (i.e.
Total Debts including current liabilities) 31.8%, Earnings per share Rs.
3.16 (No. of equity shares of Rs. 10 paid up 80 lakhs); Dividend per
136
Types of Financing
share Rs. 1.50 (These all relate to the last year).
Harbour Co. has been invited to bid on a long-term contract to
produce a line of plastics for a large chemical company. It appears
that the firm can easily get Rs. 600 lakhs contract, which will yield an
additional Rs. 180 lakhs in operating income (EBIT). These figures
are for next year only and the firm estimates even higher sales and
profits in future years.
The production manager knows of a small plastics company located
about three kilometers away from the present factory and has all the
equipment needed to produce the new line of plastics and the
company is presently for sale with a Rs. 1,050 lakhs asking price
(which represents largely the value of the assets). The company is
available at the negotiated price of Rs. 900 lakhs.
Harbour Co. has sufficient working capital to add the new plastic line,
but does not have the cash to buy Rs. 900 lakhs for machinery and
equipment. The following financing options are available:
(i) Harbour Co. can borrow Rs. 400 lakhs through a 12% mortgage on
its main facilities. A mortgage company has indicated that it
would help finance the plastic machinery with a Rs. 500 lakhs,
12% mortgage. Harbour as per its policy wants to keep debt
asset ratio between 40 per cent.
(ii) The company can probably issue upto Rs. 1,000 lakhs in 13%
preferred stock or class A equity shares. If equity shares are
issued, it could net Rs. 50 per share.
Harbour Co. shares has traditionally traded at a 15/1 price-
earnings multiple and it is expected that this will hold in the
future. (Corporate Income-tax 50%).
Required:
1. Analysis needed to decide whether to accept the plastic
project.
2. Recommendation on the financing method of the project.
(20 marks) (May 2000)
Answer
(1) Analysis of the decision whether to accept the plastic
project
Current position:
Sales Rs. 1,500 lakhs, Net profit after tax Rs. 250 lakhs
Net profit before tax Rs. 500 lakhs (Tax 50%)
137
Total assets Rs. 2,200 lakhs,
Debt asset ratio (i.e. total debts including Current Liabilities) =
31.8%
Hence Debt = 31.8% Rs. 2,200 lakhs = Rs. 700 lakhs
Equity Balance = Rs. 2,200 lakhs 700 lakhs = Rs. 1,500 lakhs.
Return on capital employed Rs.
22.7% 100 lakhs
2,200
500

Project details:
Sales Rs. 600 lakhks, Operating income Rs. 180 lakhs, Investment
Rs. 900 lakhs
Return on new project = 20% 100 lakhs
900
180
Rs. 100
investment
income Operating

Cost of capital for the project for alternative financing
methods:
(i) Loan against Mortgage 12% interest
(ii) Preference shares 13% i.e. 13% out of post tax profits i.e. pre-
tax cost 26% (exceeds the return of 20% on new project)
(iii) Equity shares at Rs. 50 per share
,
_
lakhs 18 i.e.
50 Rs.
lakhs 900 Rs.
issued be to shares of . no
Dividend 15%, hence post-tax cost 6% cost tax - pre 3%,
5
15

P
Div.
K Or
0
e

Where,
Div. = Dividend per share,
P
0
= Price per share
K
e
= Cost of equity
50
1.50
K
e

= 3%, Pre-tax cost = 6%.
138
Types of Financing
Since the earnings are more than the cost against loan and
equity, one should go for the project by financing either by
loan/equity or combination of both.
(2) Computation of Earning per share when new project is
financed by either loan or equity
Debt Rs.
900 lakhs
Equity Rs.
900 lakhs
(Rs. in lakhs)
Expected operating profit
of project
180 180
Less: Interest on debt (12% on Rs. 900
lakhs) 108

Profit before tax 72 180
Less: Taxation (50%) 36 90
Profit after tax 36 90
Existing profit after tax 250 250
Profit available to equity
shareholders
286 340
No. of shares 80 lakhs 80 lakhs + 18
lakhs = 98
lakhs
Earnings per share Rs. 3.575 Rs. 3.469
Market price Rs. 3.575 15
= Rs. 53.62
Rs. 3.469 15 = Rs. 52.03
Debt asset ratio
900 Rs. 2,200 Rs.
900 Rs. 700 Rs.
+
+
900 Rs. 2,200 Rs.
700 Rs.
+
51.6% 22.6%
Since the debt option exceeds the debt asset ratio of 40% we
cannot go fully on financing by debt option though it gives higher
earning per share.
Computation of maximum debt for new project
In order to keep debt asset ratio of 40%, total debt including the
project
should not exceed (Rs. 2,200 + Rs. 900) lakhs 40%
139
Rs. 1,240 lakhs
Less: Existing debt Rs.
700 lakhs
Maximum debt which can be taken on the new project
Rs. 540 lakhs
Against mortgage of plastic machinery Rs. 500 lakhs can be
obtained @ 12% and balance Rs. 400 lakhs can be raised by issue
of equity shares @ Rs. 50 per share
Computation of Earning per share when new project is
financed by debt of Rs. 500 lakhs and equity of Rs. 400
lakhs
(Rs.in
lakhs)
Expected operating profit of project 180
Less: Interest on debt (12% on Rs. 500 lakhs) 60
Profit before tax 120
Less: Taxation (50%) 60
Profit after tax 60
Existing profit after tax 250
Profit available to equity shareholders 310
No. of shares 80 lakhs + 8 lakhs 88 lakhs
Earning per share Rs. 3.523
Debt asset ratio
40%) than (less 38.7% lakhs
3,100
1,200
Rs. lakhs
900 2,200
500 700
. Rs
+
+
Market price = Rs. 3.523 15 = Rs. 52.85
Recommendation: Since Earning per share (EPS) is higher when
company raises funds for investment in new project by borrowing
against mortgage of Rs. 500 lakhs and raising equity capital of Rs.
400 lakhs. The company should opt for this alternative.
Question 12
A company is evaluating a new venture that will cost Rs. 10 crores.
The venture will have a return on investment of 20 per cent and the
firm forecasts a 12 per cent growth in earnings from the project. The
140
Types of Financing
treasurer has identified the following sources for financing the
project:
(a) Equity shares to be sold at Rs. 400 per share.
(b) Convertible debentures with a 6 per cent coupon to net Rs. 980
(face value Rs. 1,000), and convertible at Rs. 500 per share after
2002.
(c) Debentures with warrants with a 6 per cent coupon to net Rs. 980
(face value Rs. 1,000), and with each bond having one warrant
entitling the holder to buy one equity share at Rs. 500 after 2002.
The financing decision is being made in the fourth quarter of 2000.
Over the past ten years, a company has been growing at a 10 per
cent rate of sales and earnings.
The treasurer expects the company to continue to grow at 10 per
cent even though the firm has traditionally paid 40 per cent of its
earnings as dividends. The treasurer expects As equity shares to
continue to rise in price. Using the price trend over the past 5 years,
he has projected probable market price ranges for the next three
years. The historical data and the projections of the treasurer are
given below:
Year Historica
l Market
price
Year Forecasted
Probability Market
Price
Rs. Rs.
1995 220 2001 20% 450
1996 250 60% 500
1997 330 20% 600
1998 270 2002 20% 480
1999 380 60% 550
Current 450 20% 620
2003 20% 500
60% 600
20% 700
141
The proforma Balance Sheet and Income Statement prepared by the
treasurer for the year 2000 is shown below:
A Company Ltd. Proforma Balance Sheet (December 31, 2000)
(Rs.0
00)
2000 1999 2000 1999
Equity Shares (Rs.
10)
10,00
0
10,00
0
Plant and
Equipment
2,52,0
00
2,31,0
00
Share Premium
Retained Earnings
40,00
0
1,36,
000
40,00
0
1,27,
000
(Less:
Accumulated
Depreciation
(62,0
00)
(59,0
00)
Bonds (7%) 90,00
0
52,00
0
1,90,0
00
1,72,0
00
Mortgage (6%) 30,00
0
55,00
0
Inventories 64,00
0
62,00
0
Accounts Payable 7,000 6,000 Receivables 44,00
0
45,00
0
Other Current
Liabilities
11,00
0
10,00
0
Cash and Bank
Balances
22,00
0
18,00
0
______
_
______
_
Other Current
Assets
4,0
00
3,0
00
3,24,
000
3,00,
000
3,24,0
00
3,00,0
00
Proforma Income Statement (Rs.000)
Sales EBIT Interest* EBT NIAT EPS
2000 4,20,00
0
71,500 8,000 63,500 31,750 31.75
1999 3,80,00
0
65,000 7,000 58,000 29,000 29.00
*Rounded off.
The management of A Ltd. was initially impressed by the fact that the
new venture will increase sales by Rs. 12 crores. Management is also
interested in the expected 12 per cent growth rate of the venture. As
per Companys Financial Policy, the firms debt-asset ratio should not
142
Types of Financing
be above 40 per cent.
With the above information and detailed analysis for next 3 years,
what will be the long-term sources of financing for the new proposal?
Make suitable assumptions in your answer, wherever necessary
figures could be rounded off. Income-tax rate applicable to the
company is to be taken at 50%.(20 marks) (November, 2000)
Answer
The various steps for detailed analysis of given information for next 3
years for determining the long term sources of financing for the new
proposal costing Rs. 10 crore are as follows:
Step 1 : Determining the size of offering for various sources of
financing
(i) Equity shares to be sold at Rs. 400 per share
Cost of new venture = Rs. 10 crore
No. of equity shares to be offered =
400 Rs.
crores 10 Rs.
= 2,50,000 shares
(ii) Convertible debentures with a 6% coupon to net Rs. 980 (face
value Rs. 1,000), and convertible at Rs. 500 per share after 2002..
No. of debentures to be offered = off) (rounded 1,02,000
980 Rs.
crores 10 Rs.
(iii) Debentures with warrants with a 6 per cent coupon to net Rs. 980
(face value Rs. 1,000) and with each bond having one warrant
entitling the holder to buy one equity share at Rs. 500 after 2002.
No. of debentures to be offered = off) (rounded 1,02,000
980 Rs.
crores 10 Rs.
Step 2 : Computation of earnings before interest and tax

(EBIT) for next year
EBIT (without new venture) = Current EBIT Growth factor
= Rs. 7.15 crores 1.10
= Rs. 7.865 crores
EBIT (with new venture) = Current EBIT Growth factor
+ Investment in new venture
R.O.I of new venture
143
= Rs. 7.15 crores 1.10 + Rs. 10 crores
20%
= Rs. 7.865 crores + Rs. 2 crores
= Rs. 9.865 crores
Step 3 : Computation of Earnings before interest and tax
(EBIT) after 3 years (at the end of planning horizon)
EBIT (without new venture) = Current EBIT (Growth factor)
3
= Rs. 7.15 crores (1.10)
3
= Rs. 9.517 crores
EBIT (with new venture) = Current EBIT (Growth factor)
3
+ Investment in new
venture (R.O.I of new venture)
2
= Rs. 7.15 crores (1.10)
3
+ Rs. 10 crores

(20%) (1.12)
2
= Rs. 9.5166 crores + Rs. 2.5088 crores
= Rs. 12.0254 crores
Step 4: To determine likelihood of issue of equity shares by
conversion of debentures into equity or by exercise of
warrants after year 2002
Expected price of equity shares during 3 year planning period.
Year 2001 2002 2003
Rs. Rs. Rs.
Rs. 450 20% =
90
Rs. 480 20% =
96
Rs. 500 20% =
100
Rs. 500 60% =
300
Rs. 550 60% =
330
Rs. 600 60% =
360
Rs. 600 20% =
120
Rs. 620 20% =
124
Rs. 700 20% =
140
Expected price
510

550
600
Since the expected price of equity shares is more than the conversion
144
Types of Financing
and option price of Rs. 500 per share, it is likely that some equity will
be created by 2003 as a result of conversion or exercise of warrants,
if one of these financing method is used.
Step 5 : Calculation of the effect on EBIT due to exercise of
warrants
In forecasting future earnings per share, the firm must consider a
likely profit on the additional capital provided by the exercise of
warrants.
EBIT (if warrants are exercised) = Rs. 5.10 crores 12.54%
= 0.63954 crores
(Refer to working notes 1 & 2)
Step 6: Statement showing computation of Earnings per share
for next years for various alternatives
(Rs. in crores)
Alternatives
No new
venture
Equity
share
Convert
ible
debt
Warrant
debt
Earning before interest
and tax
7.865 9.865 9.865 9.865
Less: Interest old debt 0.810 0.810 0.810 0.810
New debt 0.612 0.612
(Refer to working note 4) _____ _____ _____ _____
Earning before tax (EBT) 7.055 9.055 8.443 8.443
Less: Tax @ 50% 3.5275 4.5275 4.2215 4.2215
Earning after tax (EAT) 3.5275 4.5275 4.2215 4.2215
No. of shares (lakhs) 10 12.5 10 10
Earning per share (Rs.) 35.27 36.22 42.215 42.215
Step 7: Statement showing computation of Earnings per share
at the end of planning horizon for various alternatives
Alternatives
No new
venture
Equity
share
Convert
ible
debt
Warrant
debt
Earnings before interest
and tax (EBIT)
9.516 12.025
4
12.0254 12.0254
145
Add: Earnings before
interest & tax by
Exercise of warrants

0.63954
(Refer to step 5)
Less: Interest old debt 0.810 0.810 0.810 0.810
New debt

0.612
Earning before tax (EBT) 8.706 11.215
4
11.2154 11.2429
Less: Tax @ 50% 4.353 5.6077 5.6077 5.6214
Earning after tax (EAT) 4.353 5.6077 5.6077 5.6214
No. of shares (lakhs) 10 12.50 12.04 11.2
(Refer to working
note 1)
(Refer to working
note 2)
Earning per share (EPS)
(Rs.)
43.53 44.86 46.57 51.00
Step 8: Computation of increase in retained earnings for
various alternatives can be determined as follows:
2
years of No. payout) Dividend - (1 tax after Earnings years 3 tax after earnings year 1st +
years 3 60%
2
crores 4.353 Rs. crores 3.52 Rs.
venteure new No
+
= Rs. 7.085 crores

years 3 60%
2
s 5.608crore Rs. crores 4.527 Rs.
shares equity of Issue
+
= Rs. 9.121 crores

years 3 60%
2
crores 5.608 Rs. crores 4.2215 Rs.
debetures e convertibl of Issue
+
= Rs. 8.846 crores

years 3 60%
2
s 5.621crore Rs. crores 4.2215 Rs.
debt warrant of Issue
+
= Rs. 8.858 crores

Step 9: Analysis for measuring the degree of risk in capital
structure
146
Types of Financing
(Rs. in crores)
No new
venture
Equity
share
Convert
ible
debt
Warrant
debt
End of the year 2000
Old debt 12.0 12.0 12.0 12.0
New debt

10.2 10.2
12.0 12.0 22.2 22.2
Old equity 18.6 18.6 18.6 18.6
New equity 10.0
18.6 28.6 18.6 18.6
Debt asset ratio 39.2% 29.6% 54.5% 54.5%
End of the year 2003
Old debt 12.0 12.0 12.0 12.0
New debt

10.2
12.0 12.0 12.0 22.2
Old equity 18.6 18.6 18.6 18.6
New equity 10.0 10.2 5.10
Increase in retained
earnings
7.0865 9.121 8.846 8.858
25.6865 37.721 37.646 32.558%
Debt asset ratio 31.8% 24.1% 24.1% 40.5%
Working Notes:
1. Equity shares from conversion of debentures:
Debentures issued Shares per debenture (on conversion)
= 1,02,000 debentures 2 share per debenture
= 2,04,000 shares
Equity shares from exercise of warrants
Bonds issued Shares per bond (Exercise of warrants)
= 1,02,000 bonds 1 share per bond
= 1,02,000 shares
Value of shares = 1,02,000 shares Rs. 500 (option price)
= Rs. 5.10 crores
147
2. Return on new equity shares (on exercise of warrants)
The return on additional capital provided by the exercise of
warrants to issue equity shares is the lower figure between
average return for the firm and the return on the new
proposal if adopted.
Average return on market value of firm
shares equity of vlaue Market Debt
EBIT

+
450) Rs. shres lakhs (10 crores) 3 Rs. crores 9 (Rs.

crores 7.15 . Rs

+ +
crores 45 Rs. crores 12 Rs.

crores 7.15 . Rs

+
crores 57 Rs.
crores 7.15 . Rs

= 12.54%
R.O.I from new proposal = 20%
Since the average return on market value of firm is lower than
R.O.I. from new proposal (20%). Hence, return on new equity
shares on exercise of warrants is 12.54%.
3. Interest on old debt
(Rs. in crores)
7% Bonds of Rs. 9 crores 0.630
6% Mortgage of Rs. 3 crores 0.810
0.810
4. Interest on new debt
6% debentures of Rs. 10.2 crores = Rs. 0.612 crores
Conclusions:
1. Issue of equity shares for financing the project offers high
earnings and is within the companys Financial Policy.
2. Issue of convertible debentures for financing the project offers
high earnings but the firms debt asset ratio exceeds 40% now
and there is a possibility of it being within the companys
Financial Policy by year 2003.
148
Types of Financing
3. Issue of warrants for financing the project offers high earnings
but is beyond the company Financial Policy (Debt asset ratio
exceeds 40%) both now and in the year 2003.
In conclusion, the firm should consider financing the project to
gain the large rise in earnings. The equity shares only or a
mixture of equity shares and debt financing, represents the most
attractive financing alternative. With mixed financing, the firm
can achieve a significant rise in earnings without increasing the
risk of exceeding the 40 per cent debt asset guidelines.
Assumptions:
1. It is assumed that the earnings from new project occurs at the
end of the year.
2. It is assumed that the debentures will be converted into
shares in the year 2003.
3. It is assumed that all the holders of the warrants will buy
equity shares in the year 2003.
Question 13
The HLL has Rs. 8.00 crore of 10% mortgage bonds outstanding under
an open-end scheme. The scheme allows additional bonds to be
issued as long as all of the following conditions are met:
(1) 4. than greater remains
Interest Bond
Interest Bond tax before Income
coverage interest tax - Pre
,
_
+
(2) Net depreciated value of mortgage assets remains twice the
amount of the mortgage debt.
(3) Debt-to-equity ratio remains below 5.
The HLL has net income after taxes of Rs. 2 crores and a 40% tax-
rate, Rs. 40 crores in equity and Rs. 30 crores in depreciated assets,
covered by the mortgage.
Assuming that 50% of the proceeds of a new issue would be added to
the base of mortgaged assets and that the company has no Sinking
Fund payments until next year, how much more 10% debt could be
sold under each of the three conditions? Which protective covenant
is binding? (12 marks)
(May 2001)
Answer
Let x be the crores of Rupees of new 10% debt which would be sold
under each of the three given conditions. Now, the value of x under
each of the three conditions is as follows:
149
1. 4. than greater remains
Interest Bond
Interest Bond tax before Income
coverage interest tax - Pre
,
_
+
0.1) (x 0.1) crores (8
0.1 x 0.1 crores 8 0.4) - (1 / crores 2 . Rs

+ +
0.10x) Rs. crores (0.80
0.10x crores 0.80 crores 3.33 . Rs
Or
+
+ +
0.10x Rs. crores 0.80 Rs.
0.10x crores 4.13 . Rs
Or
+
+
Or Rs. 4.13 crores + 0.10x = 4 (Rs. 0.80 crores + Rs. 0.10x)
Or Rs. 4.13 crores + 0.10x = Rs. 3.2 crores + Rs. 0.40x
Or Rs. 0.30x = 0.93
Or x = Rs. 0.93/0.30
Or x = Rs. 3.10 crores
Additional mortgage required shall be a maximum of Rs. 3.10
crores.
2. Net depreciated value of mortgage assets remains twice
the amount of mortgage debt
(Assuming that 50% of the proceeds of new issue would be added
to the base of mortgaged assets)
2
x crores 8 Rs.
0.5x crores 30 . Rs
.e. i
+
+
or Rs. 30 crores + 0.5x = 2 (Rs. 8 crores + x)
or Rs. 1.5x = Rs. 14 crores
1.5
crores 14 . Rs
x or
or x = 9.33 crores
Additional mortgage required to satisfy condition No. 2 is Rs. 9.33
crores
3. Debt to equity ratio remains below 5
5
crores 40 Rs.
x crores 8 . Rs
. e . i <
+
or Rs. 8 crores + x = Rs. 200 crores
or x = Rs. 192 crores
150
Types of Financing
Since all the conditions are to be met, the least i.e. Rs. 3.10
crores (as per condition 1) can be borrowed by issuing additional
bonds.
Note: Since in the question, it is given that Debt to equity ratio
remains below 5, the value of debt is computed by using this
condition. However, the new additional debt (x) is exorbitant and
is not comparable with the value of new additional debt (x)
computed under conditions 1 and 2. For getting the comparable
value of new additional debt x the debt to equity ratio should be
read as 0.5. Accordingly, value of additional debt would be Rs. 12
crores.
Question 14
Consider the following information for Strong Ltd.
EBIT 1,120 Rs. in lakh
PBT 320 Rs. in lakh
Fixed cost 700 Rs. in lakh
Calculate the percentage of change in earnings per share, if sales
increased by 5 per cent.
Answer
Computation of percentage of change in earnings per share, if
sales increased by 5%.
sales in change %
(EPS) share per Earning in change %
leverage combined of Degree
sales in change %
leverage financial of Degree leverage operating of Degree or
5
(ii) and (i) notes working to (Refer 3.5 1.625 or
5
5.687 or
or % change in EPS = 5.687 5
= 28.4375%
Working Notes:
(i)
EBIT
on Contributi
(DOC) leverage operating of Degree
151

lakhs 1,120 Rs.
lakhs) 700 Rs. 1,120 (Rs.

+
= 1.625
(ii)
PBT
EBIT
(DOF) leverage financial of Degree

320 Rs.
1,120 Rs.

= 3.5
Question 15
(a) A firm has a bond outstanding Rs. 3,00,00,000. The bond has 12
years remaining until maturity, has a 12.5 per cent coupon and is
callable at Rs. 1,050 per bond; it had floatation costs of Rs.
4,20,00, which are being amortised at Rs. 30,000 annually. The
floatation costs for a new issue will be Rs. 9,00,000 and the
current interest rate will be 10 per cent. The after tax cost of the
debt is 6 per cent. Should the firm refund the outstanding debt?
Show detailed workings. Consider Corporate Income-tax rate at
50%.
(b) IOPS has an equity capital of 12 million, total debt of 8 million and
sales last year were 30 million:
(i) It has a target Assets-to-Sales ratio of .667, a target Net Profit
margin of .04, a target D.E. ratio of .667 and target earnings
retention rate of .75. In a steady state, what is its sustainable
growth rate?
(ii) Suppose the company has established for the next year a
target Assets-to-Sales ratio of .62, a target Net Profit margin
of .05, and a target D.E. ratio of .80. It wishes to pay an
annual dividend of 3 million and raise 1 million in equity
capital next year. What is its sustainable growth rate for next
year?
(Million = Million Rupees) (8 + 6 = 14 marks)
(November, 2001)
Answer
(a) (i) Differential Annual Interest Saving
Rs.
Interest on outstanding bonds
(Rs. 3,00,00,000 12.5%)
37,50,000
152
Types of Financing
Interest on new issue of bonds
(Rs. 3,00,00,000 10%)
30,00,000
Annual interest savings (before tax) 7,50,000
Less: Tax @ 50% 3,75,000
Annual interest saving (after tax): (i) 3,75,000
Remaining life of outstanding bonds 12 years
Rate of return 6%
Present value of Annuity (6%, 12 years)
(ii)
8.384
Present value of annual interest saving
(after tax), (i), (ii)
31,44,000
(ii) Saving of call premium
Call premium = Callable value Face value
= Rs. 1,050 Rs. 1,000
= Rs. 50 per bond or 5% of face value.
= Rs. 15,00,000 (5% of Rs. 3,00,00,000)
Saving of call premium after tax = Rs. 7,50,000 (15,00,000
50%)
Note: The call premium can be written off as an expense in
year the call is made.
(iii) Floatation Costs
The floatation costs for new issue of Rs. 9,00,000 will be cash
outflow at the time of new issue.
(iv) Saving on amortisation of floatation costs
Rs.
Floatation cost of new issue 9,00,000
Annual floatation cost of new issue 75,000
Tax rate 50%
Saving of annual floatation cost (after tax) 3,75,000
No. of years 12
PVAF for 12 years at 6% rate of interest 8.384
Saving of floatation cost (after tax): 3,14,400
(v) Differential tax saving from amortisation of old issue:
153
Present value of immediate tax savings Rs. 1,80,000
Present value of tax saving
(If firm retain outstanding debt) (Rs. 30,000
50% 8.384)
Rs. 1,25,760
Present value of tax saving (Rs. 1,80,000 Rs.
1,25,760)
Rs. 54,240
Net after tax saving from new issue = (A) (B)
(C) + (D) + (F)
= Rs. 31,44,000 Rs. 7,50,000 Rs. 9,00,000 + Rs.
3,14,400 + Rs. 54,240
= Rs. 18,62,640
Since net savings of Rs. 18,62,640 appears to be a major benefit
from refunding of outstanding debt of Rs. 3,00,00,000 bond.
Hence, the firm should refund the outstanding debt.
(b) (i) Sustainable growth rate (SGR)
1
]
1
,
_
+
,
_
,
_
,
_
+
,
_
Eq
D
1
S
NP
b -
S
A
Eq
D
1
S
NP
b

Where,
b = Retention rate of earnings (1-b is the dividend
payout ratio)
NP/S = Net profit margin (net profits divided by sales)
D/Eq = Debt to equity ratio
S = Annual Sales
A/S = Assets to Sales ratio
Now,
Here, A/s = 0.667, NP/S = 0.04, D/E = 0.667 and b =
0.75
0.667)] (1 (0.04) (0.75) - [0.667
0.667) (1 (0.04) 0.75
SGR
+
+
= 8.11%
(ii) Sustainable growth rate for next year
154
Types of Financing
( )
1 -
S
1

A
S

Eq
D
1
S
NP
- 1
A
S

Eq
D
1 Div - Eq New Eq
SGR
0
0
1
]
1
1
1
1
1
1
]
1
1
]
1
,
_
,
_
+
,
_
,
_
,
_
+ +
NP/S. D/Eq, S, A/S are the same as stated in (i) above

Where, S
0
= Most recent annual sales.
Eq
0
= Equity in the beginning
Now, Here A/S = 0.62, NP/S = 0.05, D/Eq = 0.80, Div = 3
million and New
Eq = Rs. 1 million S
0
= 30 million
( ) ( ) ( )
( ) ( ) ( ) [ ]
1 -
30
1

1.6129 80 . 1 0.05 - 1
1.6129 80 . 0 1 0.3 - 1 12
SGR
1
]
1
1
]
1
+ +
= 43.77%
Question 16
G Manufacturing Company is an important producer of lawn furniture
and decorative objects for the patio and garden. The last years
Income Statement and Balance Sheet are as follows:
Income Statement
Rs.
Sales 75,00,000
Variable Costs 46,90,000
Contribution 28,10,000
Fixed Costs 14,00,000
Earnings before interest and Tax (EBIT) 14,10,000
Interest 2,00,000
Earnings before Tax (EBT) 12,10,000
Taxation 6,05,000
Net Income after tax 6,05,000
Balance Sheet
Liabilities Rs. Assets Rs.
Equity Capital 10,00,000 Fixed Assets 60,00,000
Reserves and Surplus 42,00,000 Inventory 6,00,000
Long-term Debt (10%) 20,00,000 Receivables 7,00,000
155
Current Liabilities 5,00,00
0
Cash 4,00,000
77,00,000 77,00,000
Figures for industry comparison:
Normal Asset Turnover 1.2 : 1
Normal Profit Margin 20%.
For the Current Year, the forecasted sales are Rs. 80,00,000 and it is
likely that variable costs will remain at approximately the same
percentage of sales as was in the last year. (Figures could be rounded
off). Fixed costs will rise by 10%.
G has short listed the following two product lines to be sold through
its existing distribution channels:
(1) Production and Sale of metal table and chair unit that will be sold
for issue around swimming pools. This will require an investment
of Rs. 20,00,000, which would involve installation of
manufacturing and packaging machinery. Sales forecast are Rs.
15,00,000 per annum, variable costs account for 2/3rd of sales
value, fixed costs are Rs. 2,00,000 and no additional working
capital is needed.
(2) Hardwood Planter with three separate components, will be
appropriate for medium sized shrubs. This will require an
investment of Rs. 30,00,000 with forecasted sales per annum of
Rs. 25,00,000, variable costs 64% of sales value and fixed costs
of Rs. 5,00,000.
Two Financial Plans are available:
(a) It could borrow on a 10 years note at 9 per cent for either or
both of the projects of an amount not to exceed Rs.
60,00,000.
(b) Cumulative Preference shares with a 10 per cent dividend
upto an amount of Rs. 30,00,000.
Financing through the issue of equity shares would not be
possible at the present time.
Required:
(1) Without the new proposal, what would be the companys
operating, Fixed charges and Combined leverages next year?
Would the Company have favourable financial leverage?
156
Types of Financing
(2) How does the acceptance of each project affect the differing
leverages including asset leverages?
(3) With each financing alternatives, do the Companys future
earnings per share increase or decrease, Why?
Answer
Working Notes:
(i) Statement showing earnings of Company
Last Year Current
Year
Rs. Rs.
Sales 75,00,000 80,00,000
Less: Variable Costs 46,90,000 50,00,000
Contribution 28,10,000 30,00,000
Less: Fixed Costs 14,00,000 15,40,000
Earnings before interest and Tax
(EBIT)
14,10,000 14,60,000
Less: Interest 2,00,000 2,00,000
Earnings before Tax (EBT) 12,10,000 12,60,000
Less: Tax (50%) 6,05,000 6,30,000
Earnings after tax (EAT) 6,05,000 6,30,000
(1) Computation of the Companys Operating, Fixed
Charges and Combined leverages for next year (Refer
to Working Note(i))

EBIT
on Contributi
Leverage Operating

14,60,000 Rs.
30,00,000 Rs.

= 2.05479
157
EBT
EBIT
Leverage nancial Charges/Fi Fixed

12,60,000 Rs.
14,60,000 Rs.

= 1.58
EBT
on Contributi
Leverage Combined

12,60,000 Rs.
30,00,000 Rs.

= 2.38
100
employed Capital
EBIT
employed Capital on return s Company'

100
72,00,000 Rs.
14,60,000 Rs.

= 20.3%

Sales
EBIT
Margin Profit

80,00,000 Rs.
14,60,000 Rs.

= 18.25%
Employed Capital
Sales
Leverage sset turnover/A - Assets

72,00,000 Rs.
80,00,000 Rs.

= 1.11
Yes, the Company would have a favourable financial leverage.
This is because the company is earning 20.3% on the capital
158
Types of Financing
employed and is paying 10% on long term debt.
(ii) Working Note:
Statement showing earnings of the Projects
Project Metal table
and Chair
Unit
Hardwood
Planter
(Rs.
20,00,000)
(Rs.
30,00,000)
Investments Investments
Sales 15,00,000 25,00,000
Less: Variable Costs 10,00,000 16,00,000
Contribution 5,00,000 9,00,000
Less: Fixed Costs 2,00,000 5,00,000
Earnings before interest and Tax
(EBIT)
3,00,000 4,00,000
(2) Computation of differing leverages including asset
leverage of each project
(Refer to Working Note (ii))

EBIT
on Contributi
Leverage Operating
3,00,000 Rs.
5,00,000 Rs.
unit chair & table Metal For
= 1.67
4,00,000 Rs.
9,00,000 Rs.
Planter ardwood H For
= 2.25

Employed Capital
Sales
Leverage Asset
30,00,000 Rs.
25,00,000 Rs.

20,00,000 Rs.
15,00,000 Rs.

= 0.75 = 0.83
159
100
30,00,000 Rs.
4,00,000 Rs.
100
20,00,000 Rs.
3,00,000 Rs.
employed Capital on Return
= 15% = 13.33%
16%
25,00,000 Rs.
4,00,000 Rs.
20%
15,00,000 Rs.
3,00,000 Rs.

Sales
EBIT
Margin Profit
As per the above computation the acceptance of metal table
and chair product will adversely affect the operating leverage,
return on capital employed and asset leverage. Similarly,
acceptance of Hardwood Planter will adversely affect the
return on capital employed and asset leverage.
(3) The effect of financing alternatives on Companys
future earnings per share.
(a) To borrow on a 10 year note at 9% for either or both of
the projects of an amount not to exceed Rs. 60,00,000.
(b) The cost of borrowing for this alternative is 9%. The return
on capital employed of first project i.e. metal table and chair
unit is 15% and for second project i.e. Hardwood planter is
13.33%. Since for both the projects earnings are higher
than the cost of borrowing the balance earning after paying
interest obligation will be available to equity shareholders.
Hence, with this financing alternative the earnings per share
will increase.
(b) To issue a cumulative preference shares with a 10% dividend upto
an amount of Rs. 30,00,000.
Since the company can raise an amount upto Rs. 30,00,000 by
issue of cumulative preference shares, whereas it requires Rs.
20,00,000 and Rs. 30,00,000 respectively for two projects.
Therefore, it can use this financing alternative for one of the two
projects because the dividend of 10% has to come from after tax
profit and tax rate is 50% therefore, pre-tax cost is 20%. The
return on capital employed of first project i.e. production and sale
of metal table and chair is 15% and of second project i.e.
Hardwood Planter with separate components is 13.33%. Since the
return of both projects are lower than the cost of 20%, hence
financing of the project under this alternative will reduce the
overall profits available to equity shareholders i.e. Earnings per
share will decrease.
Question 17
Write short note on Restrictive covenants placed by a lender on a
160
Types of Financing
borrower in cases of term lending for projects.
Answer
Restrictive covenants placed by a lender on a borrower in
cases of term lending for projects: For lending term loans for
projects, in addition to asset security, a lender to protect itself placed
a number of restrictive covenant on a borrower. The restrictive
covenants may be categorised as follows:
(i) Asset-related covenants: It requires the borrowing firm to
maintain its minimum asset base. This may include to maintain
minimum working capital position in terms of minimum current
ratio and not to sell fixed assets without the lenders approval.
(ii) Liability related covenants: It restricted borrowing firm from
incurring additional debt or repay existing loan. The borrowing
firm may be required to reduce its debt-equity ratio by issuing
additional equity and preference capital.
(iii) Cash-flow related covenants: Lenders may restrain the borrowing
firm cash outflow by restructuring cash dividends, capital
expenditures, salaries and perks of managerial staff.
(iv) Control related covenants: The lender may provide for
appointment of suitable staff and the broad-base Board of
Directors for managing the operation of borrowing firms.
(v) Convertibility: Lenders may state the terms and conditions of
conversion. For instance, FIs in India insist on the option of
converting loans into equity.
Question 18
XYZ Limited pays no taxes and is entirely financed by equity shares.
The equity share has a beta of 0.6, a price-earning ratio of 12.5 and is
priced to offer an expected return of 20 per cent. XYZ Ltd. now
decides to buy back half of the equity shares by borrowing an equal
amount. If the debt yields a riskfree return of 10%, calculate:
(i) The beta of the equity shares after the buyback.
(ii) The required return and risk premium on the equity shares before
the buyback.
(iii) The required return and risk premium on the equity shares after
the buyback.
(iv) The required return on debt.
161
(v) The percentage increase in expected earnings per share.
(vi) The new price-earning multiple.
Assume that the operating profit of the firm is expected to remain
constant in perpetuity.
(12 marks) (May 2002)
Answer
(i) Before buyback xyz is all equity financed and the equity beta is
0.6 and the expected return on equity is 20 per cent. Thus the
firms asset beta is 0.6 and the firms cost of capital is 20 per
cent. Over all firm value will not change after the buyback and
that the debt is risk-free.
( ) ( )
E D A
Beta
E D
E
Beta
E D
D
Beta
+
+
+
.6 = .5 0 + .5 Beta
E
or Beta
E
= 1.20
(ii) Before financing, the required rate of return on equity is 20 per
cent and the risk-free rate is 10 per cent. Thus the risk premium
on equity is 10 per cent.*
*If beta = .6 is considered then Risk Premium will be = .1667 i.e.
16.67%
Calculated as follows
r
A
= r
A
+ (r
m
- r
A
)

20 per cent = 10 + (x 10)
x.6
10 = (x 10)
x(0.6)
cent per 16.67
0.6
10
x
(iii) After financing
E
E
A
r
E D
E
r
E D
D
r
d
+
+
+
.20 = .5 .10 + .5 r
E
OR 30%. or .30
.5
.05 - .20
r
E

Thus, the risk premium on Equity is 20 per cent.*
* If beta = 1.2 is considered then Risk Premium will be = .1667
i.e. 16.67% calculated as follows.
162
Types of Financing
30 = 10 + (r
m
10) 1.2
16.67%
1.2
20
Premium Risk
(iv)The required rate of return on debt is 10 per cent i.e. risk free
rate.
(v) The percentage increase in EPS has been calculated as follows by
assuming the following figures.
Before
buyback
After
buyback
Equity 100 50
Debt @ 10% Nil 50
100 100
EBIT @ 20% 20 20
Interest Nil 5
Earnings before tax 20 15
Tax Nil Nil
Earnings after tax 20 15
No. of shares 100 50
Earnings per share 0.2 0.3
P/E Ratio 5 3.33
Return on Equity 20% 30%
The percentage increase in EPS is 50 per cent i.e. (0.3 0.2) / 0.2
100
= 50 per cent.
(vi)The new price-earning multiple is 3.33.
Question 19
A company has a book value per share of Rs. 137.80. Its return on
equity is 15% and it follows a policy of retaining 60% of its earnings.
If the Opportunity Cost of Capital is 18%, what is the price of the
share today? (6 marks) (May 2002)
Answer
The company earnings and dividend per share after a year are
expected to be:
EPS = Rs. 137.8 0.15 = Rs. 20.67
163
Dividend = 0.40 20.67 = Rs. 8.27
The growth in dividend would be:
g = 0.6 0.15 = 0.09
g - K
Dividend
P : Formula model growth Perpetual
e
0

0.09 - 0.18
8.27
P
0

P
0
= Rs. 91.89
Alternative Solution:
However, in case a student follows Walters approach as against
continuous growth model given in previous solution the answer of the
question works out to be different. This can be shown as follow:
Given data:
Book value per share = Rs. 137.80
Return on equity = 15%
Dividend Payout = 40%
Cost of capital = 18%
EPS = Rs. 137.80 15%
= Rs. 20.67
Dividend = Rs. 20.67 40%
= Rs. 8.27
Walters approach showing relationship between dividend and share
price can be expressed by the following formula
( )
c
c
a
c
R
D - E
R
R
D
V
+
Where,
V
c
= Market Price of the ordinary share of the company.
R
a
= Return on internal retention i.e. the rate company earns on
retained profits.
R
c
= Capitalisation rate i.e. the rate expected by investors by way
of return from particular category of shares.
E = Earnings per share.
164
Types of Financing
D = Dividend per share.
Hence,
( )
.18
8.27 - 20.67
.18
.15
8.27
V
c
+
.18
18.60

= Rs. 103.35
Question 20
A project had an equity beta of 1.2 and was going to be financed by a
combination of 30% debt and 70% equity.
Assuming debt-beta to be zero, calculate the Project beta taking risk-
free-rate of return to be 10% and return on market portfolio at 18%.
(4 marks) (May 2002)
Answer
1
]
1
+
+
1
]
1
+

E D
D
debt
E D
E
equity
p
= (1.2 .7) + (0 .3) = .84
RRR = R
f
+
p
(R
m
R
f
)
= .10 + 0.84 (.18 - .10)
= .1672 or 16.72%
Question 21
A Ltd. is an all equity Financed Company. The current market price of
share is Rs. 180. It has just paid a dividend of Rs. 15 per share and
expected future growth in dividend is 12%. Currently, it is evaluating
a proposal requiring funds of Rs. 20 lakhs, with annual inflows of Rs.
10 lakhs for 3 years. Find out the Net Present Value of the proposal,
if (i) It is financed from retained earnings; and (ii) It is financed by
issuing fresh equity at market price with a floatation cost of 5% of
issue price. (6 marks) (May 2002)
Answer
(i) Calculation of Net Present Value
Financed From Retained Earnings:
Cost of Retained Earnings:
165
Dividend of Rate rowth G 100
Share of Price Market Current
year the of end the at dividend Expected
+
1
]
1
21.33% 2% 1 100
180 Rs.
80 . 1 15 . Rs
+
1
]
1
+
NPV of the Proposal: Net Cash Flow
Year Rs.
0
20,00,000
1 (10,00,000 .8242) 8,24,200
2
(10,00,000 .6793)
6,79,300
3 (10,00,000 .5599) 5,59,900
63,400
(ii) Financed through issue of Fresh Equity:
Rate rowth G 100
cost) floatation - (1 P
D
Equity of Cost
0
1
+
1
]
1

21.82% 2% 1
.05) - (1 180 Rs.
80 . 1 15 . Rs
+
1
]
1
+
NPV of the Proposal:
Net Cash flow
Year Rs.
0
20,00,000
1 (10,00,000 .8209) 8,20,900
2
(10,00,000 .6738)
6,73,800
3 (10,00,000 .5532) 5,53,200
NPV 47,900
166
Types of Financing
Question 22
The net Sales of A Ltd. is Rs. 30 crores. Earnings before interest and
tax of the company as a percentage of net sales is 12%. The capital
employed comprises Rs. 10 crores of equity, Rs. 2 crores of 13%
Cumulative Preference Share Capital and 15% Debentures of Rs. 6
crores. Income-tax rate is 40%.
(i) Calculate the Return-on-equity for the company and indicate its
segments due to the presence of Preference Share Capital and
Borrowing (Debentures).
(ii) Calculate the Operating Leverage of the Company given that
combined leverage is 3.
(6 + 4 = 10 marks) (May 2002)
Answer
(i) Net Sales : Rs. 30 crores
EBIT Rs. 3.6 crores @ 12% on sales
20% 100
6 2 10
3.6
100
Employed Capital
EBIT
ROI
+ +

Rs. in crores
EBIT 3.6
Interest on Debt 0.9
EBT 2.7
Less: Tax @ 40% 1.08
EAT 1.62
Less: Preference dividend 0.26
Earnings available for Equity
Shareholders
1.36
Return on equity = 1.36/10
100 = 13.6%
Segments due to the presence of Preference
share capital and Borrowing (Debentures)
Segment of ROE due to Preference capital: [.20 (1.4) .13] .2 =
.002
Segment of ROE due to Debentures: [.20 (1.4) .15 (1 .4)] .6
= .018 or .2% + 1.8%
167
= 1.6%
The weighted average cost of capital is as follows:
Source Proportion Cost
(%)
WACC
(%)
(i) Equity 10/18 13.60 7.56
(ii) Preference Shares 2/18 13.00 1.44
(iii
)
Debt 6/18 9.00 3.00
Total 12.00
(ii)
dividend Preference - Interest - EBIT
EBIT
Leverage Financial of Degree
1.4754
.26 - .9 - 3.6
3.6

Degree of Combined Leverage = DFL DOL

1.4754
3
DOL or DOL 1.4754 3
Degree of operating leverage = 2.033
Question 23
Pragya Limited has issued 75,000 equity shares of Rs. 10 each. The
current market price per share is Rs. 24. The company has a plan to
make a rights issue of one new equity share at a price of Rs. 16 for
every four share held.
You are required to:
(i) Calculate the theoretical post-rights price per share;
(ii) Calculate the theoretical value of the right alone;
(iii) Show the effect of the rights issue on the wealth of a shareholder,
who has 1,000 shares assuming he sells the entire rights; and
(iv) Show the effect, if the same shareholder does not take any action
and ignores the issue.
(8 marks)(May 2003)
Answer
(i) Calculation of theoretical Post-rights (ex-right) price per share:
Ex-right value =
1
]
1
+
+
R N
R S MN
168
Types of Financing
Where M = Market price,
N = Number of old shares for a right share
S = Subscription price
R = Right share offer
=
1
]
1
+
+
1 4
1) 16 (Rs. 4) 24 (Rs.
= Rs. 22.40
(ii) Calculation of theoretical value of the rights alone:
= Ex-right price Cost of rights share
= Rs. 22.40 Rs. 16 = Rs. 6.40
(iii) Calculation of effect of the rights issue on the wealth of a
shareholder who has 1,000 shares assuming he sells the entire
rights:
Rs.
(
a
)
Value of shares before right issue
(1,000 shares Rs. 24) 24,000
(
b
)
Value of shares after right issue
(1,000 shares Rs. 22.40) 22,400
Add: Sale proceeds of rights
renounciation
(250 shares Rs. 6.40)
1,600
24,000
There is no change in the wealth of the shareholder if he does not
take any action and ignores the issue.
(iv)Calculation of effect if the shareholder does not take any action
and ignores the issue:
Rs.
Value of shares before right issue
(1,000 shares Rs. 24) 24,000
Less: Value of shares after right issue
(1,000 shares Rs. 22.40) 22,400
Loss of wealth to shareholders, if rights
ignored
1,600
169
Question 24
A company is presently working with an earning before interest and
taxes (EBIT) of Rs. 45 lakhs. Its present borrowings are:
(Rs. Lakhs)
12% term loan 150
Working capital:
Borrowing from Bank at 15% 100
Public deposit at 11% 45
The sales of the company is growing and to support this the company
proposes to obtain additional borrowing of Rs. 50 lakhs expected to
cost 16%. The increase in EBIT is expected to be 16%.
Calculate the change in interest coverage ratio after the additional
borrowing and commitment.
(8 marks)(May 2003)
Answer
Calculation of Present Interest Coverage Ratio
Present EBIT = Rs. 45 lakhs
Interest charges (Present) Rs. in lakhs
Term loan @ 12% 18.00
Bank Borrowings @ 15% 15.00
Public Deposit @ 11% 4.95
37.95
Present Interest Coverage Ratio =
es arg Ch Interest
EBIT
1.19
lakhs 37.95 Rs.
lakhs 45 Rs.

Calculation of Revised Interest Coverage Ratio
Revised EBIT (116% of Rs. 45 lakhs) = 52.2 lakhs
Proposed interest charges Rs. in lakhs
Existing charges 37.95
Add: Additional charges (16% of additional
Borrowings i.e. 50 lakhs) 8.00
Total 45.95
170
Types of Financing
1.14
lakhs 45.95 Rs.
lakhs 52.2 Rs.
Ratio coverage interest vised Re
Analysis: With the proposed increase in the sales the burden of
interest on additional borrowings of Rs. 50 lakhs will adversely affect
the interest coverage ratio which has been reduced by 5%
approximately (i.e. from 1.19 to 1.14).
Question 25
M/s Agfa Industries is planning to issue a debenture series on the
following terms:
Face value Rs. 100
Term of maturity 10 years
Yearly coupon rate
Years
1 4 9%
5 8 10%
9 10 14%
The current market rate on similar debentures is 15 per cent per
annum. The Company proposes to price the issue in such a manner
that it can yield 16 per cent compounded rate of return to the
investors. The Company also proposes to redeem the debentures at
5 per cent premium on maturity. Determine the issue price of the
debentures.
Answer
The issue price of the debentures will be the sum of present value of
interest payments during 10 years of its maturity and present value of
redemption value of debenture.
Years Cash out flow
(Rs.)
PVIF @ 16% PV
1 9 .862 7.758
2 9 .743 6.687
3 9 .641 5.769
4 9 .552 4.968
171
5 10 .476 4.76
6 10 .410 4.10
7 10 .354 3.54
8 10 .305 3.05
9 14 .263 3.682
10 14 + 105 = 119 .227 3.178 +
23.835
71.327
Thus the debentures should be priced at Rs. 71.327
Question 26
There is a 9% 5-year bond issue in the market. The issue price is Rs. 90
and the redemption price Rs. 105. For an investor with marginal income
tax rate of 30% and capital gains tax rate of 10% (assuming no
indexation), what is the post-tax yield to maturity? (5 marks)(May
2004)
Answer
Calculation of yield to Maturity (YTM)
Price)/2 Purchase price n (Redemptio
disc. rated - Pro Coupon
YTM
+
+
After tax coupon = 9 (1 .30) = 6.3%

After tax redemption price = 105 (15 .10) or Rs. 103.5
After tax capital gain = 103.5 90 = Rs. 13.5
( )
9.30%
96.75
0 0 9.
or
90)/2 (103.5
13.5/5 6.3
YTM
+
+
Question 27
Calculate economic value added (EVA) with the help of the following
information of Hypothetical Limited:
Financial leverage : 1.4 times
Capital structure : Equity Capital Rs. 170 lakhs
Reserves and surplus Rs. 130 lakhs
10% Debentures Rs. 400 lakhs
Cost of Equity : 17.5%
Income Tax Rate : 30%. (6 marks)
172
Types of Financing
(November, 2004)
Answer
Financial Leverage = PBIT/PBT
1.4 = PBIT / (PBIT Interest)
1.4 = PBIT / (PBIT 40)
1.4 (PBIT 40) = PBIT
1.4 PBIT 56 = PBIT
1.4 PBIT PBIT = 56
0.4 PBIT = 56
or lakhs 140 Rs.
0.4
56
PBIT
NOPAT = PBIT Tax = Rs. 140 lakhs (1 0.30) = Rs. 98 lakhs.
Weighted average cost of capital (WACC) = 17.5% (300 / 700)+ (1
0.30) (10%) (400 / 700)
= 11.5%
EVA = NOPAT (WACC Total Capital)
= Rs. 98 lakhs 0.115 Rs. 700 lakhs
= Rs. 17.5 lakhs
Question 28
ABC Limiteds shares are currently selling at Rs. 13 per share. There
are 10,00,000 shares outstanding. The firm is planning to raise Rs.
20 lakhs to Finance a new project.
Required:
What is the ex-right price of shares and the value of a right, if
(i) The firm offers one right share for every two shares held.
(ii) The firm offers one right share for every four shares held.
(iii) How does the shareholders wealth change from (i) to (ii)? How
does right issue increases shareholders wealth?
(6 marks)(November, 2004)
Answer
(i) Number of shares to be issued : 5,00,000
173

10 Rs.
15,00,000
20,00,000 0 1,30,00,00 Rs.
right - Per
+
Subscription price Rs. 20,00,000 / 5,00,000 = Rs. 4

3
2
4 - 10 Rs.
right of Value
(ii)
12 Rs.
12,50,000
20,00,000 0 1,30,00,00 Rs.
right - Per
+
Subscription price Rs. 20,00,000 / 2,50,000 = Rs. 8

1 Re.
4
8 - 12 Rs.
right of Value .
(iii) Since right issue is constructed in such a way so that
shareholders proportionate share will remain unchanged,
shareholders wealth does not change from (i) to (ii).
Right issue increases shareholders wealth because the cost of
issuing right shares is much lower than the cost of a public issue.
Question 29
(a) The following data are available for a bond
Face value Rs. 1,000
Coupon Rate 16%
Years to Maturity 6
Redemption value Rs. 1,000
Yield to maturity 17%
What is the current market price, duration and volatility of this
bond? Calculate the expected market price, if increase in
required yield is by 75 basis points.
(8 Marks) (November, 2005)
Answer
(a) 1. Calculation of Market price:
2
value Market Value Face

left Years
premium or Discount
interest Coupon
TM Y
+
,
_
Discount or premium YTM is more than coupon rate, market

price is less than Face Value i.e. at discount.
Let x be the market price
174
Types of Financing
2
x 1,000

6
x) - (1,000
160
17 . 0
+
'
x = Rs. 960.26
Alternatively, the candidate may attempt by
160 (PVIFA 17,6) + 1,000 (PVIFA 17,6)
= 160 (3.589) + 1,000 (.390)
= 574.24 + 390
= 964.24
2. Duration
Year Cash flow P.V. @ 17% Proporti
on of
bond
value
Proportion
of bond
value x
time
(years)
1 160 .855 136.8 0.142 0.142
2 160 .731 116.96 0.122 0.244
3 160 .624 99.94 0.104 0.312
4 160 .534 85.44 0.089 0.356
5 160 .456 72.96 0.076 0.38
6 1160 .390 452.4 0.467 2.802
964.4 1.000 4.236
Duration of the Bond is 4.236 years

3. Volatility
1.17
4.236

yields) (1
Duration
bonds the of olatility V
+

= 3.62
4. The expected market price if increase in required yield is by
75 basis points.
= Rs. 960.26 .75 (3.62/100)
175
= Rs. 26.071
Hence expected market price is Rs. 960.26 Rs. 26.071 = Rs.
934.189
Hence, the market price will decrease
This portion can also be alternatively done as follows
= Rs. 964.4 .75 (3.62/100)
= Rs. 26.18
then the market price will be
= Rs. 964.4 26.18 = Rs. 938.22
Question 30
M/s Transindia Ltd. is contemplating calling Rs. 3 crores of 30 years,
Rs. 1,000 bond issued 5 years ago with a coupon interest rate of 14
per cent. The bonds have a call price of Rs. 1,140 and had initially
collected proceeds of Rs. 2.91 crores due to a discount of Rs. 30 per
bond. The initial floating cost was Rs. 3,60,000. The Company
intends to sell Rs. 3 crores of 12 per cent coupon rate, 25 years bonds
to raise funds for retiring the old bonds. It proposes to sell the new
bonds at their par value of Rs. 1,000. The estimated floatation cost is
Rs. 4,00,000. The company is paying 40% tax and its after cost of
debt is 8 per cent. As the new bonds must first be sold and their
proceeds, then used to retire old bonds, the company expects a two
months period of overlapping interest during which interest must be
paid on both the old and new bonds. What is the feasibility of
refunding bonds? (5 Marks) (November, 2005)
Answer
NPV for bond refunding
Rs.
PV of annual cash flow savings (W.N. 2)
(3,49,600 PV/FA 8,25) i.e. 10.675 37,31,98
0
Less: Initial investment (W.N. 1) 29,20,00
0
NPV 8,11,98
0
Recommendation: Refunding of bonds is recommended as NPV is
positive.
176
Types of Financing
Working Notes:
(1) Initial investment:
(a) Call premium
Before tax (1,140 1,000)
30,000
42,00,000
Less tax @ 40% 16,80,000
After tax cost of call
prem.
25,20,000
(b) Floatation cost 4,00,000
(c) Overlapping interest
Before tax (.14 2/12 3
crores)
7,00,00
0
Less tax @ 40% 2,80,00
0
4,20,000
(d) Tax saving on unamortised discount on old bond 25/30
9,00,000 .4 (3,00,000)
(e) Tax savings from unamortised floatation
Cost of old bond 25/30
3,60,000 .4
(1,20,0
00)
29,20,0
00
(2) Annual cash flow savings:
(a) Old bond
(i) Interest cost (.14 3 crores)
42,00,0
00
Less tax @ 40% 16,80,0
00
25,20,00
0
(ii) Tax savings from amortisation of
discount
9,00,000/30 .4
(12,000)
(iii) Tax savings from amortisation of
floatation
cost 3,60,000/30 .4
(4,80
0)
Annual after cost payment of Debt
(A)
25,03,20
0
(b) New bond
177
(i) Interest cost before tax (.12 3
crores)
36,00,00
0
Less tax @ 40% 14,40,00
0
After tax interest 21,60,00
0
(ii) Tax savings from amortisation of
floatation
cost (.4 4,00,000/25)
(6,400) 21,53,6
00
Annual after tax payment 3,49,6
00
Question 31
What is a re-financing? Briefly explain indicating at least two
institutions which offer such re-financing.
(4 Marks) (November, 2006)
Answer
RE-FINANCING
Re-financing is a process by which a large financial institution provides
funds or reimburses funds to another institution to help development,
relief or other similar cause identified as the purpose of the former. It
can also, in another way, be described as a wholesale distribution of
financial assistance to a retailing institution. Often, governmental
support or subsidized funding is reached to the ultimate beneficiaries,
through such channel.
NABARD is a governmental organization established with the primary
objective of financing the farm sector; it is an arm through which
government extends certain concessions/privileges to the farming
community. NABARD does not deal with farmers directly but deals with
many banks such as scheduled and nationalized banks providing re-
financing for quite a few schemes intended for the benefit of the
agricultural sector. This is one example.
SIDBI is another governmental organization whose objective is to assist
the development of small industries. It is another institution which is
engaged in refinancing activities; it funds a few schemes intended for
SSIs through scheduled/nationalized banks.
Question 32
178
Types of Financing
Find the current market price of a bond having face value Rs.1,00,000
redeemable after 6 year maturity with YTM at 16% payable annually
and duration 4.3202 years. Given 1.16
6
= 2.4364. (6 Marks) (May,
2007)
Answer
Duration 4.3202 = (1.16/0.16) [1.16 + 6 (c-0.16)]/ (c [(1.16)
6
1] +
0.16)
4.3202 =
( ) [ ] 16 . 0 1 16 . 1 c c
) 16 . 0 c ( 6 16 . 1
16 . 0
16 . 1
6
+
+
9298 . 2
16 . 0 c 4364 . 1
96 . 0 c 6 16 . 1
+
+
0.2 + 6c = 4.20836472 c + 0.468768
1.79163528c = 0.268768
C = 0.150012679
c = 0.15
Where c = Coupon rate
Therefore, current price = Rs.(1,00,000/- x 0.15 x 3.685 + 1,00,000/- x
0.410)
= Rs.96,275/-.
Question 33
(a) MP Ltd. issued a new series of bonds on January 1, 2000. The
bonds were sold at par (Rs.1,000), having a coupon rate 10% p.a.
and mature on 31
st
December, 2015. Coupon payments are made
semiannually on June 30
th
and December 31
st
each year. Assume
that you purchased an outstanding MP Ltd. Bond on 1
st
March,
2008 when the going interest rate was 12%.
Required:
(i) What was the YTM of MP Ltd. Bonds as on January 1, 2000?
(ii) What amount you should pay to complete the transaction? Of
that amount how much should be accrued interest and how
much would represent bonds basic value.
(6 Marks)( Nov, 2007)
Answer
(i) Since the bonds were sold at par, the original YTM was 10%.
179
Y + M =
% 10
000 , 1 . Rs
100 . Rs
incipal Pr
Interest
(ii) Price of the bond as on 1

st
July, 2015
= Rs.50 9.712 + 1,000
0.417
= Rs.902.60
Total value of the bond on
the next interest date
= Rs.902.60 + Rs.50
= Rs.952.60
Value of bond at
purchase date
=
Rs.952
3 / 2
) 6 . 0 1 (
1
+
= Rs.952.60 Rs.0.731004
(by using excel)
= Rs.696.35
The amount to be paid to complete the transaction is
Rs.696.35. Out of this amount Rs.16.57 represent accrued
interest and Rs.679.68 represent the bond basic value.
Alternative solution:
Bo =
+
+
+
n
t
n
m
t
t
kd
B
kd
Int
2
1
2
2
1
)
2
1 ( )
2
1 (
) (
Bo =
15 2
2
1
15 2
1
)
2
12
1 (
1000
)
2
12
1 (
) 100 (
+
+
+
t
t
Bo =
15 2
30
1
) 06 . 1 (
1000
) 06 . 1 (
50
x t
t
+
Bo = 50 13.765 + 1000 .174

= 688.25 + 174 = 862.25
Therefore Value of Bond at purchase date
= Rs 862.25 Rs 0.731004
= Rs. 630.31
The amount to be paid to complete the transaction is Rs.630.31.
Out of this amount Rs.16.57 represent accrued interest and
Rs.613.64 represent the bond basic value.
Question 34
180
Types of Financing
AB Ltd. has recently approached the shareholders of CD Ltd. which is
engaged in the same line of business as that of AB Ltd. with a bid of 4
new shares in AB Ltd. for every 5 CD Ltd. shares or a cash alternative
of Rs.360 per share. Past records of earnings of CD Ltd. had been
poor and the companys shares have been out of favour with the
stock market for some time. Pre bid information for the year ended
31.3.2006 are as follows:
AB Ltd in lakhs CD Ltd. in
lakhs
Equity share capital 60 170
Number of shares 24 17
Pre-tax profit 125 110
P/E Ratio 11 7
Estimated post tax cost of Equity
Capital per Annum
12% 10%
Both AB Ltd. and CD Ltd. pay income tax at 30%. Current earnings
growth forecast is 4% for the foreseeable future of both the Companies.
Assuming no synergy exists, you are required to evaluate whether
proposed share to share offer is likely to be beneficial to the
shareholders of both the companies using merger terms available. AB
Ltd.s directors might expect their own pre bid P/E ratio to be applied to
combined earnings.
Also comment on the value of the two Companies from the constant
growth form of dividend valuation model assuming all earnings are paid
out as dividends (14 Marks) (Nov,2007)
181
Answer
Alternative 1 (when number of shares are 2.4 and 1.7 lakhs
respectively)
Evaluation:-
Background calculations:-
(Figures in lakhs)
AB Ltd. CD
Ltd.
Total
PBT 125 110 235
PAT 87.5 77 164.5
Pre bid EPS 36.46 45.29
P/E ratio 11 7
Pre-bid Price Per Share 401.06 317.0
3
Market value of the company 962.54 538.9
5
1,501.4
9
No. of New Shares Post bid 2.4 1.36 3.76
% combined company owned by 63.83% 36.17
%
Value to the original Shareholders 958.40 543.0
9
1,501.4
9
Post bid Price per share to original
shareholders i.e., 2.40 lakhs and 1.70 lakhs
shareholders respectively.
399.33 319.4
6
(Note: The Post bid Price per share to new shareholders as per terms
of acquisition works out to Rs.399.33 for both the companies)
These figures suggest post bid acquisition share price of Rs.399.33 for
AB Ltd., and 319.46 for CD Ltd.s. Original shareholders. The price of
CD Ltd share is likely to be influenced by the value of cash alternative.
The post bid share price of the new firm can be estimated by applying
the P/E ratio to the combined earnings of the two old companies.
In that case,
Market Value would be = 164.5 11 = 1809.50
Price per share of the combined company would be =
25 . 481 . Rs
76 . 3
50 . 809 , 1
182
Types of Financing
Therefore share of AB Ltd., shareholders would raise by Rs.481.25
Rs.401.06= Rs.80.19 i.e., 20%.
Share value of CD Ltd., shareholder expected to rise by
% 44 . 21 . e . i 97 . 67 . Rs 03 . 317
5
4
25 . 481 . Rs
,
_
With the cash offer the premium is only % 55 . 13

03 . 317
03 . 317 360
Hence shareholders of CD Ltd are gaining more from the merger in a

share exchange and cash alternative is unlikely to be accepted.
Using constant growth model the value of both the individual
companies would be:
AB Ltd., share price =
98 . 473 . Rs
04 . 0 12 . 0
) 04 . 1 ( 46 . 36
CD Ltd., share price =

03 . 785 . Rs
04 . 0 10 . 0
04 . 1 29 . 45
On this basis market slightly undervalues AB Ltd share but share of CD

Ltd., are highly undervalued possibly because of previous
disappointments. However, if AB Ltd. forecast is believed that the AB
Ltd., is getting CD Ltd. shares, it will be a cheap proposal for AB Ltd. to
acquire the CD Ltd. on share exchange basis and especially if any of the
shareholder of CD Ltd. Accept the cash offer.
The shareholders of CD Ltd. would also be benefited post merger based
on share exchange ratio since the value of their share would be going up
from Rs.317.03 to Rs.399.33. However, their share price would still be
undervalued as compared with the share price calculated by using
constant growth model.
Alternative 2 (when number of shares are 24 and 17 lakhs
respectively)
If we take into consideration the number of shares being 24 lakhs and
17 lakhs the Pre-bid share price works out to Rs.40.15 and Rs.31.71
respectively, which seems to be illogical against a cash offer @ Rs.360/-
per share. However, since many students may have solved this
question based on the figures of 24 lakhs and 17 lakhs number of
shares, an alternative solution is provided below.
Evaluation: Figures in
lakhs
Background calculations: AB Ltd. CD Ltd. Total
183
PBT 125 110 235
PAT 87.5 77 164.5
Pre bid EPS 3.65 4.53
P/E Ratio 11 7
Pre-bid Price per share 40.15 31.71
Market value of the company 963.60 539.07 1502.67
No. of new shares Post-bid 24 13.6 37.6
% of combined company owned by 63.83 36.17
Value to the original shareholders 959.15 543.52 1502.67
Post-bid Price to original
shareholders i.e,, 24 lakhs and 17
lakhs shareholders respectively
39.96 31.97
(Note: The Post bid price per share works out to Rs.39.96 for both the
companies)
These figures suggest Post acquisition share price of Rs.39.96 for AB Ltd
and Rs.31.97 for CD Ltds original shareholders. The Price of CD Ltd.
Share is likely to be influenced by the value of cash alternative.
The Post bid share price of the new firm can be estimated by applying
the P/E ratio to the combined earnings of the two old companies.
In that case,
Market-value would be = 164.5 11 = 1809.50
Price per share of the combined company
Would be = 13 . 48
6 . 37
50 . 1809
Shares of AB Ltd. shareholders would raise by Rs.48.13 40.15 =

7.98 i.e., 19.87% or 20%.
Share value of CD Ltd., shareholders expected to raise by Rs.
,
_
5
4
13 . 48
31.71
= Rs.7.40 or 23.34%.
However, with the cash offer the premium is % 29 . 1035
71 . 31
71 . 31 360

Hence, the shareholders of CD Ltd., are substantially benefited by cash
offer and they are unlikely to accept the share swap ratio.
184
Types of Financing
Using constant growth model the value of shares of both the
individual companies would be
AB Ltd. Share Price =
08 . 0
80 . 3
04 . 0 12 . 0
) 04 . 1 ( 65 . 3
= Rs.47.5
CD Ltd. Share Price =
06 . 0
71 . 4
04 . 0 10 . 0
) 04 . 1 ( 53 . 4
= Rs.78.5
On this basis market slightly undervalues AB Ltd. Share but share of CD
Ltd., is highly undervalued possibly because of previous
disappointments. However, if AB Ltd. forecast is believed that the AB
Ltd. is getting CD Ltd. share it will be a cheap proposal for AB Ltd., to
acquire CD Ltd., on share exchange basis.
The shareholders of CD Ltd., would however be more benefited by
cash offer.
185
Question 35
On the basis of the following information:
Current dividend (Do) = Rs.2.50
Discount rate (k) = 10.5%
Growth rate (g) = 2%
(i) Calculate the present value of stock of ABC Ltd.
(ii) Is its stock overvalued if stock price is Rs.35, ROE = 9% and EPS
= Rs.2.25? Show detailed calculation. (6 Marks)( Nov, 2007)
Answer
(i) Present Value of the stock of ABC Ltd. Is:-
Vo =
02 . 0 105 . 0
) 02 . 1 ( 50 . 2
= Rs.30/-.
(ii)
Pay out ratio of ABC Ltd. =
25 . 2
5 . 2
= 1.111
Hence, Retention ratio = 1 -1.111
= -0.111
Or -11.1%
Sustainable growth ratio is = -0.111 0.09
= -0.00999
= -0.999%
Using the constant growth model, the value is
=
) 00999 . 0 ( 105 . 0
) 99 . 0 ( 50 . 2 . Rs

=
11499 . 0
475 . 2
= Rs.21.52
This value is less than the stock price of Rs.30/- as calculated
above or Rs.35, as given in the question, which indicates that
stock of ABC Ltd. is Overvalued.
186
Types of Financing
Alternative answer (ii)
(MV) of Stock in Rs.=
) g k (
) g 1 ( D
g k
D
e
0
e
1

=
25 . Rs
09 . 0
225 . Rs
) BV ( 30
02 . 0 105 . 0
02 . 1 5 . 2

Again
g k
g k
) BV (
) MV (
e
r
where symbols denote their usual notations.

So,
25
) MV (
085 . 0
07 . 0
, or
25
) MV (
02 . 0 105 . 0
02 . 0 09 . 0

59 . 20 . Rs 25
085 . 0
07 . 0 . Rs
) MV (
Based on
) (
) (
BV
MV
ratio and based on perpetual growth model the
price of the share should be Rs.20.59 and Rs.30respectively which
are lower than the present (MV) of Rs.35.
The stock is therefore, Overvalued.
Question 36
The following is the Balance Sheet of a Private Limited Company as at
31st March, 2008.
Capital and
Liabilities
Rs. Property and Assets Rs.
Share capital:
Authorized: 8,000
equity
shares of Rs. 100
each
10,000 11%
Cumulative
8,00,000
10,00,000
Fixed Assets:
Cost
6,00,000
Less: Depreciation
2,00,000
Current Assets:
Stock in trade
2,00,000
Sundry debtors
4,00,000
7,00,000
187
Preference shares
of
Rs. 100 each.
Issued, subscribed
and
paid up:
4,000 Equity
shares of
Rs. 100 each fully
paid up
Reserve
15% Unsecured
debentures
Trade creditors
and
creditors for
expenses
4,00,000
1,00,000
2,00,000
4,00,0
00
Rs.
11,00,000
4,00,000
Cash and bank
balance
1,00,000
__________
Rs.
11,00,000
The company finds that a very profitable market exists for its products
and with a little expansion; it could generate more sales at the present
selling prices. The expansion calls for an investment of Rs. 8,00,000 in
Fixed assets and Rs. 2,00,000 in Current assets. It is ascertained that
the current annual profits in the region of Rs. 3,00,000 will be enhanced
by 50% due to the expansion.
The debt-equity ratio applicable generally to the industry in which the
Company is engaged is 2 : 1.
Please advise the management on the various methods available to it to
meet the cost of financing the expansion, keeping in mind the interest
of the equity shareholders. (16 Marks) ( May, 2008)
Answer
Rs. Rs.
Resources needed for expansion:
10,00,000
Less: Resources available 1,00,000 9,00,000
To take care of interest of the equity shareholders, EPS has to be the
maximum in the circumstances.
188
Types of Financing
The debt-equity ratio applicable to the industry is 2:1. The equity as on
31
st
March, 2008 is Rs.5,00,000 and the debt Rs.2,00,000. Some
gearing is thus possible on the debt front.
It is also to be remembered that cost of servicing debt is an allowable
set-off against profits while cost of servicing capital is not.
The various alternatives available are considered below:-
(i) To raise the equity to the level authorized by the memorandum
and to raise the balance by issue of preference capital.
Resources needed 9,00,000
Equity capital to the extent unissued to be
issued at par
4,00,000
Balance needed 5,00,000
To be met by the issue of 5,000 11% cumulative
preference share
5,00,000
EPS then will be Rs.3,00,000 + Rs.1,50,000 55,000 8,000 viz.
Rs.49.38
(ii) To raise the entire requirements by issue of Preference Capital.
In this situation, EPS will be Rs.4,50,000 99,000 =
75 . 87 . Rs
000 , 4
000 , 51 , 3 . Rs
(iii) To raise the resources by part issue of equity and balance by way
of 15% debentures.
Resources needed Rs.9,00,000
Unissued capital 4,00,000
Issue of debentures 5,00,000
EPS in this case will be Rs.4,50,000 75,000 = 3,75,000 8,000
= Rs.46.88
(iv) The companys debt equity ratio is 0.4:1. The acceptable limit is
2:1. The company can therefore raise a debt, on the present level
of equity base to the extent of Rs.10,00,000. The existing debt
being Rs.2,00,000, balance of Rs.8,00,000 could be raised. Thus
there will be a short cover of Rs.1,00,000. To use the debt cover
to the fullest extent, the company can issue additional equity
shares of 500 making the equity base of Rs.4,50,000.
Resources needed 9,00,000
Issue of new shares 50,000
Issue of debt 8,50,000 9,00,000
189
The rate at which debt can be raised cannot be lower than what
the company is paying to the debentureholders i.e., (15%).
Assuming the cost of loan at 17%, the position of EPS will be as
under:
New profits 4,50,000
Less: Interest on borrowings 17%
on Rs.8,50,000
1,44,500
Profit available to equity holders Rs.3,05,500
EPS Rs.68
(rounded off)
A yet another method could be to issue the unissued equity
shares assuming at a premium, say of 20% and for the balance
raise preference share capital which is the least costly amongst
the various alternatives.
Resources needed Rs.9,00,00
0
Issue of 4000 equity shares at Rs.120 per share 4,80,000
Balance needed 4,20,000
Issue 4200 11% cum Preference shares at par. EPS in this
situation will be Rs.4,50,000 Rs.46,200 = 4,03,800
=
000 , 8
800 , 03 , 4
= Rs.50.48
Tabled below are the various results.
EPS at present
75 . Rs
000 , 4 . Rs
000 , 00 , 3 . Rs
(Rs.)
(i) By Combination of issue of equity and preference at
par
49.38
(ii) By Raising preference shares only 87.75
(iii
)
By part issue of equity and part debentures 46.88
(iv
)
By Predominant resort to borrowings 68.00
(v
)
Issue of part equity at a premium and the balance
preference shares
50.48
190
Types of Financing
The suggested plan, per se, will be to meet the entire costs
of expansion by issuing 11% cumulative preference shares.
Question 37
ABC Ltd. has been maintaining a growth rate of 10 percent in dividends.
The company as paid dividend @ Rs.3 per share. The rate of return on
market portfolio is 12 percent and the risk free rate of return in the
market has been observed as 8 percent. The Beta co-efficient of
companys share is 1.5.
You are required to calculate the expected rate of return on companys
shares as per CAPM model and equilibrium price per share by dividend
growth model. ( 6 marks) (Nov 2008)
Answer
CAPM formula for calculation of Expected Rate of Return is :
ER = R
f
+ B (R
m
R
f
)
= 8 + 1.5 (12 8)
= 8 + 1.5 (4)
= 8 + 6
+ 14% or 0.14
Applying Dividend Growth Model for the calculation of per share
equilibrium price :
ER =
0
1
P
D
+ g
0.14=
0
P
) 10 . 1 ( 3
+ 0.10
0.14 0.10 =
0
P
30 . 3

0.04 P
0
= 3.30
P
0
=
04 . 0
30 . 3
= Rs.82.50
Per share equilibrium price will be Rs.82.50.
Question 38
Based on the credit rating of bonds, Mr. Z has decided to apply the
following discount rates for valuing bonds :
191
Credit Rating Discount Rate
AAA 364 day T bill rate + 3% spread
AA AAA + 2% spread
A AAA + 3% spread
He is considering to invest in AA rated, Rs.1,000 face value bond
currently selling at Rs.1,025.86. The bond has five years to maturity and
the coupon rate on the bond is 15% p.a. payable annually. The next
interest payment is due one year from today and the bond is
redeemable at par. (Assume the 364 day T-bill rate to be 9%).
You are required to calculate the intrinsic value of the bond for Mr. Z.
Should he invest I the bond? Also calculate the current yield and the
Yield to Maturity (YTM) of the bond. (5 marks) (Nov 2008)
Answer
The appropriate discount rate for valuing the bond for Mr. Z is :
R = 9 + 3 + 2 = 14%
TIME CF PVIF 14% PV
(CF)
PV (CF)
1 150 877 131.55
2 150 769 115.35
3 150 675 101.25
4 150 592 88.80
5 1150 519 596.85
PV (CF)
i.e.
P
0
= 1033.80
Since, the current market value is less than the intrinsic value; Mr. Z
should buy the bond. Current yield = Annual Interest / Price = 150 /
1025.86 = 14.62%
The YTM of the bond is calculated as follows:
@15%
P = 150 PVIFA
15%, 4
+ 1150 PVIF
15%, 5
= 150 2.855 + 1150 0497
= 428.25 + 571.55 = 999.80
@14%
As found in sub part (a) P
0
= 1033.80
By interpolation we get, YTM = 14.23%
192
Types of Financing
NOTE

193

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2

Where EFR External funds requirement

= 1.5 120 14.4

(By substituting and solving the equation)

1.5 LT = Rs. 600

Debt equity ratio, if Rs. 10 lakhs (additional investment) were to

Probable price of equity share = Rs. 13.07 10

lakhs 37.50 Rs.

lakhs 37.50 Rs.

Step 2 : Computation of earnings before interest and tax

= Rs. 7.085 crores

= Rs. 9.121 crores

= Rs. 8.846 crores

= Rs. 8.858 crores

450) Rs. shres lakhs (10 crores) 3 Rs. crores 9 (Rs.

crores 45 Rs. crores 12 Rs.

NP/S. D/Eq, S, A/S are the same as stated in (i) above

After tax coupon = 9 (1 .30) = 6.3%

Subscription price Rs. 20,00,000 / 5,00,000 = Rs. 4

Subscription price Rs. 20,00,000 / 2,50,000 = Rs. 8

Discount or premium YTM is more than coupon rate, market

(ii) Price of the bond as on 1

Bo = 50 13.765 + 1000 .174

With the cash offer the premium is only % 55 . 13

Hence shareholders of CD Ltd are gaining more from the merger in a

CD Ltd., share price =

On this basis market slightly undervalues AB Ltd share but share of CD

Shares of AB Ltd. shareholders would raise by Rs.48.13 40.15 =

where symbols denote their usual notations.

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