Chapter 15: Capital Structure Theory and Policy

Problem 1

NI approach: No debt 300,000 debt 600,000 debt

Investment 1,000,000 1,000,000 1,000,000
Debt 0 300,000 600,000
Interest rate 16% 16% 16%
Equity-capitalisation rate, ke 18% 18% 18%

NOI 200,000 200,000 200,000

Interest (16%) 0 48,000 96,000
NI 200,000 152,000 104,000
Market value of equity, E =NI/ke 1,111,111 844,444 577,778
Market value of debt, D 0 300,000 600,000
Value of the firm, V +E + D 1,111,111 1,144,444 1,177,778
WACC, NOI/V 18.0% 17.5% 17.0%

NOI approach: No debt 300,000 debt 600,000 debt

Investment 1,000,000 1,000,000 1,000,000
Debt 0 300,000 600,000
Interest rate 16.00% 16.00% 16.00%
Over-all capitalisation rate, ko 12.00% 12.00% 12.00%

NOI 200,000 200,000 200,000

Interest 0 48,000 96,000
NI 200,000 152,000 104,000
Value of the firm, V = NOI/ko 1,666,667 1,666,667 1,666,667
Market value of debt, D 0 300,000 600,000
Market value of equity, E = V - D 1,666,667 1,366,667 1,066,667
Cost of equity, ke = NI/E 12.0% 11.1% 9.8%
Problem 2
U L
Assets 800,000 800,000
Debentures 0 400,000
ROI 18% 18%
Cost of debt 0% 12%
Corporate tax rate 50% 50%
Pure equity-capitalisation rate 15% 15%
NOI approach:
NOI 144,000 144,000
Tax 72,000 72,000
After-tax NOI 72,000 72,000
Value of the firm, V 480,000 480,000
WACC, After-tax NOI/V 15.0% 15.0%
NI approach:
NOI 144,000 144,000
Interest 0 48,000
PBT 144,000 96,000
Tax 72,000 48,000
NI 72,000 48,000
Interest tax shield 0 24,000
Value of equity, E = V - D 480,000 320,000
Value of debt, D 0 400,000
Value of the firm, V 480,000 720,000

Arbitrage:
Investment in L's shares 5%
Investment value: 5% x 320,000 16,000
Return from the investment: 5% x 48,000 2,400

Sell shares in L (cash inflow) 16,000

Borrow equal to 5% of U's debt:
5% x (1-0.50) x 400,000 10,000
Total available cash 26,000
Buy 5% of U's shares: 5% x 480,000 24,000
Remaining cash 2,000
Return:
Return from U's shares: 5% x 72,000 3,600
Less: cost of borrowed funds: 10,000 x 12% 1,200
Net return 2,400
Problem 3

X Y
NOI 200,000 200,000
Interest 0 36,000
Net income 200,000 164,000
Value of equity, E 1,800,000 1,312,000
Value of Debt, D 0 600,000
Value of firm, V 1,800,000 1,912,000
Cost of equity, ke 11.10% 12.50%
Cost of debt, kd 0.00% 6.00%
Cost of capital, k0 11.10% 10.50%
Corporate leverage: D/E 0.00% 45.73%

Percentage shares held in Y: (20/1312) 1.52%

Value of investment in Y 20,000.00
Return: (20/1312) x 164,000 2,500.00

Sell shares in the levered firm Y 20,000.00

Borrow on personal account:(600/1312)x20,000 9,146.34
Total cash available 29,146.34

Buy share of unlevered firm X: (20/1312) x 27,439.02

1,800,000
Return: (20/1312) x 200,000 3,048.78
Less: interest on personal debt: 9,146.34 x 6% 548.78
Net return 2,500.00
Surplus cash available: 29,146.34 - 27,439.02 1,707.32

Problem 4

A B
NOI 150,000 150,000
Interest 0 30,000
NI 150,000 120,000
Equity-capitalisation rate, ke 10% 15%
Value of shares, E 1,500,000 800,000
Value of debt, D 0 500,000
Value of the firm, V 1,500,000 1,300,000
Overall capitalisation rate 10.0% 11.5%
Investment in A's shares 10%
Investment value 150,000
Return 15,000

Sell share in A 150,000

Return
Buy shares in B 80,000 12,000
Lend at 6% in firm B 50,000 3,000
Investment 130,000 15,000
Surplus cash 20,000

Problem 5

Unlevered Levered (L)

Value of shares, E (U)
500,000 280,000
Value of debt, D 0 250,000
Value of the firm, V 500,000 530,000
Cost of debt, kd 0% 6%

NOI 50,000 50,000

Interest 0 15,000
NI 50,000 35,000
Cost of equity, ke = NI/E 10.0% 12.5%
WACC, k0 = NOI/V 10.0% 9.4%

Investment in L's shares 5.00%

Investment value: 5% x 280,000 14,000
Return: 5% x 35,000 1,750

Sell shares in the levered firm 14,000

Borrow equal to L's debt: 5% x 250,000 12,500
Total cash available 26,500

Invest in U's shares (5%) 25,000

Return: 5% x 50,000 2,500
Less: interest on debt: 6% x 12,500 750
Net return 1,750
Surplus cash 1,500
Problem 6
Traditional approach
Debt ratio kd ke k0
0.0% 0.0% 12.5% 12.5%
10.0% 5.0% 13.0% 12.2%
20.0% 5.0% 13.6% 11.9%
30.0% 6.0% 14.3% 11.8%
40.0% 7.0% 16.0% 12.4%
50.0% 8.0% 18.0% 13.0%
60.0% 10.0% 20.0% 14.0%
M-M approach:
Debt ratio kd ke k0
0.0% 0.0% 12.5% 12.5%
10.0% 5.0% 13.3% 12.5%
20.0% 5.0% 14.4% 12.5%
30.0% 6.0% 15.3% 12.5%
40.0% 7.0% 16.2% 12.5%
50.0% 8.0% 17.0% 12.5%
60.0% 10.0% 16.3% 12.5%

Problem 7

X Y
Expected NOI 50,000 50,000
Cost of debt, INT = kd x D 0 10,000
Net income, NI 50,000 40,000
Cost of equity, ke 10.0% 11.1%
Value of shares, E 500,000 360,000
Value of debt, D 0 200,000
Value of the firm, V = E + D 500,000 560,000
Average cost of capital, ko = NOI/V 10.0% 8.9%
D/E ratio 0.0% 55.6%

Cost of capital, ko - MM thesis (given) 12.5% 12.5%

Value of the firm, V - MM thesis: 400,000 400,000
NOI/k
Value of
o debt, D 0 200,000
Value of shares, E = V - D 400,000 200,000
Problem 8

M N
NOI 12,000 12,000
Interest, INT 0 2,000
NI 12,000 10,000
Overall capitalisation rate, ko 8% 8%
Value of the firm, V = NOI/ko 150,000 150,000
Value of debt, D 0 40,000
Value of shares, E = V - D 150,000 110,000
Cost of debt, kd = INT/D 0.0% 5.0%
Cost of equity, ke = NI/S 8.0% 9.1%
Traditional view:
Cost of equity, ke 10.0% 10.5%
Value of shares, E = NI/ke 120,000.0 95,238.1
Value of debt, D = INT/kd 0 40,000.00
Value of the firm, V = E + D 120,000.0 135,238.1
Overall capitalisation rate,
ko = ke x (S/V) + kd x (D/V) 10.0% 8.9%

Problem 9

I II III IV
Corporate tax 0% 0% 50% 50% 50% 50% 50% 50%
Personal tax- dividend 0% 0% 0% 0% 30% 30% 20% 20%
Personal tax- interest 0% 0% 0% 0% 30% 30% 40% 40%
U L U L U L U L
Equity 100,000 50,000 100,000 50,000 100,000 50,000 100,000 50,000
Debt 0 50,000 0 50,000 0 50,000 0 50,000
Cost of debt 0% 15% 0% 15% 0% 15% 0% 15%

NOI 25,000 25,000 25,000 25,000 25,000 25,000 25,000 25,000

Interest 0 7,500 0 7,500 0 7,500 0 7,500
Taxable income 25,000 17,500 25,000 17,500 25,000 17,500 25,000 17,500
Corporate tax 0 0 12,500 8,750 12,500 8,750 12,500 8,750
Net income 25,000 17,500 12,500 8,750 12,500 8,750 12,500 8,750
Invesors' net income:
Dividend income 25,000 17,500 12,500 8,750 12,500 8,750 12,500 8,750
Tax on dividend 0 0 0 0 3,750 2,625 2,500 1,750
After-tax dividend income 25,000 17,500 12,500 8,750 8,750 6,125 10,000 7,000
Interest income 0 7,500 0 7,500 0 7,500 0 7,500
Tax on interest income 0 0 0 0 0 2,250 0 3,000
After-tax interest income 0 7,500 0 7,500 0 5,250 0 4,500
After-tax total income 25,000 25,000 12,500 16,250 8,750 11,375 10,000 11,500
Interest tax shield 0 3,750 2,625 1,500
Cost of debt (after personal tax) 15.0% 15.0% 10.5% 9.0%
Value of interest tax shield 0 25,000 25,000 16,667
Problem 10

Target debt-equity ratio 1.0

Target payout ratio 40%
Growth rate 20%
Before -tax ROI 21%
Interest rate 12%
Sales-to-assets ratio 1.8
Tax rate 35%
Sustainable growth
.4[{.21 + (.21 - .12)1}(1-.35)] 7.8%

Problem 11

Hindustan Lever Ltd. (HLL) (Rs crore)

Year GFA NCA INVST NW Debt NS PBIT INT PAT
1992 330.5 323.1 12.3 333.3 200.3 1221.1 197.0 32.2 60.0
1993 365.6 285.8 51.0 385.7 115.2 1505.0 244.9 27.2 79.8
1994 491.8 299.7 191.5 538.3 146.5 1721.3 327.4 29.5 97.3
1995 563.8 193.0 122.8 638.3 160.2 2039.4 385.2 20.2 122.1
1996 953.6 168.9 328.8 937.5 260.1 2798.8 654.2 57.0 185.2
1997 1035.2 567.2 544.6 1260.8 186.6 3337.8 874.2 33.9 232.0
1998 1273.4 895.3 729.5 1712.4 264.3 6560.7 1130.5 29.3 404.7
1999 1349.7 1151.8 1068.1 2102.6 177.3 7736.8 1420.1 22.4 570.3
2000 1539.4 1087.1 1832.2 2487.6 111.6 9426.1 1668.4 13.2 808.2
2001 1778.3 1349.7 1668.9 3043.0 83.7 10116.5 1865.6 7.7 1079.8
2002 1836.9 1639.0 2397.7 3658.2 58.3 10588.2 2154.4 9.2 1300.3

Capital structure analysis Invstments anf Financing

Year Debt ratio D/E Coverage Capex INVST NCA NW Debt
1992 37.5% 0.60 6.1 - - - - -
1993 23.0% 0.30 9.0 35.1 38.7 -37.3 52.4 -85.1
1994 21.4% 0.27 11.1 126.2 140.5 13.9 152.6 31.3
1995 20.1% 0.25 19.1 72.0 -68.7 -106.7 100.0 13.7
1996 21.7% 0.28 11.5 389.8 206.0 -24.1 299.2 99.9
1997 12.9% 0.15 25.8 81.6 215.8 398.3 323.3 -73.5
1998 13.4% 0.15 38.6 238.2 184.9 328.1 451.6 77.7
1999 7.8% 0.08 63.4 76.3 338.6 256.5 390.2 -87.0
2000 4.3% 0.04 126.4 189.7 764.1 -64.7 385.0 -65.7
2001 2.7% 0.03 242.3 238.9 -163.3 262.6 555.4 -27.9
2002 1.6% 0.02 234.2 58.6 728.8 289.3 615.2 -25.4
 Profitability analysi
Year NS/CE PBIT/NS PBIT/CE PAT/PBIT CE/NW ROE
1992 2.3 16.1% 36.9% 30.5% 1.60 18.0%
1993 3.0 16.3% 48.9% 32.6% 1.30 20.7%
1994 2.5 19.0% 47.8% 29.7% 1.27 18.1%
1995 2.6 18.9% 48.2% 31.7% 1.25 19.1%
1996 2.3 23.4% 54.6% 28.3% 1.28 19.8%
1997 2.3 26.2% 60.4% 26.5% 1.15 18.4%
1998 3.3 17.2% 57.2% 35.8% 1.15 23.6%
1999 3.4 18.4% 62.3% 40.2% 1.08 27.1%
2000 3.6 17.7% 64.2% 48.4% 1.04 32.5%
2001 3.2 18.4% 59.7% 57.9% 1.03 35.5%
2002 2.8 20.3% 58.0% 60.4% 1.02 35.5%

Problem 12

Philips India Ltd. (Rs crore)

Year GFA NCA INVST NW TD STBB LTB DEBN NS PAT
1990 154.7 82.1 2.1 41.3 116.5 12.1 104.4 56.7 391.2 -8.2
1991 162.1 97.1 7.6 63.6 101.8 16.0 85.8 48.3 523.1 26.7
1992 181.8 122.9 12.2 76.5 114.6 31.1 83.6 41.2 689.5 21.5
1993 232.1 112.8 13.8 129.3 69.3 6.4 52.9 22.8 672.0 9.0
1994 253.1 141.3 13.2 175.9 62.5 12.8 39.6 3.2 1092.7 33.7
1995 319.2 223.4 14.7 187.4 169.7 91.3 63.4 3.0 1454.4 22.1
1996 376.1 194.3 19.6 190.9 186.9 71.5 100.3 32.7 1438.8 11.8
1997 386.0 175.8 16.7 171.7 168.3 47.6 80.7 32.7 1509.4 44.6
1998 414.8 217.8 15.5 176.2 195.7 44.8 110.9 72.2 1620.1 39.2
1999 330.4 213.1 14.0 191.6 159.9 35.4 104.5 50.0 1662.9 41.4
2000 363.3 134.1 14.0 167.8 127.3 25.8 86.5 53.8 1444.4 -3.1
2001 334.7 40.0 17.3 147.3 66.1 45.9 20.2 0.0 1459.5 40.4
2002 605.4 67.6 1.9 306.4 48.0 5.5 42.5 8.3 1492.8 85.5

Percentage of Capital Employed

Year NS/CE PAT/NS ROE TD STBB LTB DEBN
1990 2.48 -2.1% -19.9% 73.8% 7.7% 66.2% 35.9%
1991 3.16 5.1% 42.0% 61.5% 9.7% 51.9% 29.2%
1992 3.61 3.1% 28.1% 60.0% 16.3% 43.7% 21.6%
1993 3.38 1.3% 7.0% 34.9% 3.2% 26.6% 11.5%
1994 4.58 3.1% 19.2% 26.2% 5.4% 16.6% 1.3%
1995 4.07 1.5% 11.8% 47.5% 25.6% 17.8% 0.8%
1996 3.81 0.8% 6.2% 49.5% 18.9% 26.5% 8.7%
1997 4.44 3.0% 26.0% 49.5% 14.0% 23.7% 9.6%
1998 4.36 2.4% 22.2% 52.6% 12.0% 29.8% 19.4%
1999 4.73 2.5% 21.6% 45.5% 10.1% 29.7% 14.2%
2000 4.89 -0.2% -1.8% 43.1% 8.7% 29.3% 18.2%
2001 6.84 2.8% 27.4% 31.0% 21.5% 9.5% 0.0%
2002 4.21 5.7% 27.9% 13.5% 1.6% 12.0% 2.3%