Problem_SolChapter 15: Capital Structure Theory and PolicyProblem 1NI approach:No debt300,000 debt600,000 debtInvestment1,000,0001,000,0001,000,000Debt0300,000600,000Interest rate16%16%16%Equity-capitalisation rate, ke18%18%18%NOI200,000200,000200,000Interest (16%)048,00096,000NI200,000152,000104,000Market value of equity, E =NI/ke1,111,111844,444577,778Market value of debt, D0300,000600,000Value of the firm, V +E + D1,111,1111,144,4441,177,778WACC, NOI/V18.0%17.5%17.0%NOI approach:No debt300,000 debt600,000 debtInvestment1,000,0001,000,0001,000,000Debt0300,000600,000Interest rate16.00%16.00%16.00%Over-all capitalisation rate, ko12.00%12.00%12.00%NOI200,000200,000200,000Interest048,00096,000NI200,000152,000104,000Value of the firm, V = NOI/ko1,666,6671,666,6671,666,667Market value of debt, D0300,000600,000Market value of equity, E = V - D1,666,6671,366,6671,066,667Cost of equity, ke = NI/E12.0%11.1%9.8%Problem 2ULAssets800,000800,000Debentures0400,000ROI18%18%Cost of debt0%12%Corporate tax rate50%50%Pure equity-capitalisation rate15%15%NOI approach:NOI144,000144,000Tax72,00072,000After-tax NOI72,00072,000Value of the firm, V480,000480,000WACC, After-tax NOI/V15.0%15.0%NI approach:NOI144,000144,000Interest048,000PBT144,00096,000Tax72,00048,000NI72,00048,000Interest tax shield024,000Value of equity, E = V - D480,000320,000Value of debt, D0400,000Value of the firm, V480,000720,000Arbitrage:Investment in L's shares5%Investment value: 5% x 320,00016,000Return from the investment: 5% x 48,0002,400Sell shares in L (cash inflow)16,000Borrow equal to 5% of U's debt:5% x (1-0.50) x 400,00010,000Total available cash26,000Buy 5% of U's shares: 5% x 480,00024,000Remaining cash2,000Return:Return from U's shares: 5% x 72,0003,600Less: cost of borrowed funds: 10,000 x 12%1,200Net return2,400Problem 3XYNOI200,000200,000Interest036,000Net income200,000164,000Value of equity, E1,800,0001,312,000Value of Debt, D0600,000Value of firm, V1,800,0001,912,000Cost of equity, ke11.10%12.50%Cost of debt, kd0.00%6.00%Cost of capital, k011.10%10.50%Corporate leverage: D/E0.00%45.73%Percentage shares held in Y: (20/1312)1.52%Value of investment in Y20,000.00Return: (20/1312) x 164,0002,500.00Sell shares in the levered firm Y20,000.00Borrow on personal account:(600/1312)x20,0009,146.34Total cash available29,146.34Buy share of unlevered firm X: (20/1312) x 1,800,00027,439.02Return: (20/1312) x 200,0003,048.78Less: interest on personal debt: 9,146.34 x 6%548.78Net return2,500.00Surplus cash available: 29,146.34 - 27,439.021,707.32Problem 4ABNOI150,000150,000Interest030,000NI150,000120,000Equity-capitalisation rate, ke10%15%Value of shares, E1,500,000800,000Value of debt, D0500,000Value of the firm, V1,500,0001,300,000Overall capitalisation rate10.0%11.5%Investment in A's shares10%Investment value150,000Return15,000Sell share in A150,000ReturnBuy shares in B80,00012,000Lend at 6% in firm B50,0003,000Investment130,00015,000Surplus cash20,000Problem 5Unlevered (U)Levered (L)Value of shares, E500,000280,000Value of debt, D0250,000Value of the firm, V500,000530,000Cost of debt, kd0%6%NOI50,00050,000Interest015,000NI50,00035,000Cost of equity, ke = NI/E10.0%12.5%WACC, k0 = NOI/V10.0%9.4%Investment in L's shares5.00%Investment value: 5% x 280,00014,000Return: 5% x 35,0001,750Sell shares in the levered firm14,000Borrow equal to L's debt: 5% x 250,00012,500Total cash available26,500Invest in U's shares (5%)25,000Return: 5% x 50,0002,500Less: interest on debt: 6% x 12,500750Net return1,750Surplus cash1,500Problem 6Traditional approachDebt ratiokdkek00.0%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 ratiokdkek00.0%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 7XYExpected NOI50,00050,000Cost of debt, INT = kd x D010,000Net income, NI50,00040,000Cost of equity, ke10.0%11.1%Value of shares, E500,000360,000Value of debt, D0200,000Value of the firm, V = E + D500,000560,000Average cost of capital, ko = NOI/V10.0%8.9%D/E ratio0.0%55.6%Cost of capital, ko - MM thesis (given)12.5%12.5%Value of the firm, V - MM thesis: NOI/ko400,000400,000Value of debt, D0200,000Value of shares, E = V - D400,000200,000Problem 8MNNOI12,00012,000Interest, INT02,000NI12,00010,000Overall capitalisation rate, ko8%8%Value of the firm, V = NOI/ko150,000150,000Value of debt, D040,000Value of shares, E = V - D150,000110,000Cost of debt, kd = INT/D0.0%5.0%Cost of equity, ke = NI/S8.0%9.1%Traditional view:Cost of equity, ke10.0%10.5%Value of shares, E = NI/ke120,000.095,238.1Value of debt, D = INT/kd040,000.00Value of the firm, V = E + D120,000.0135,238.1Overall capitalisation rate,ko = ke x (S/V) + kd x (D/V)10.0%8.9%Problem 9IIIIIIIVCorporate tax0%0%50%50%50%50%50%50%Personal tax- dividend0%0%0%0%30%30%20%20%Personal tax- interest0%0%0%0%30%30%40%40%ULULULULEquity100,00050,000100,00050,000100,00050,000100,00050,000Debt050,000050,000050,000050,000Cost of debt0%15%0%15%0%15%0%15%NOI25,00025,00025,00025,00025,00025,00025,00025,000Interest07,50007,50007,50007,500Taxable income25,00017,50025,00017,50025,00017,50025,00017,500Corporate tax0012,5008,75012,5008,75012,5008,750Net income25,00017,50012,5008,75012,5008,75012,5008,750Invesors' net income:Dividend income25,00017,50012,5008,75012,5008,75012,5008,750Tax on dividend00003,7502,6252,5001,750After-tax dividend income25,00017,50012,5008,7508,7506,12510,0007,000Interest income07,50007,50007,50007,500Tax on interest income000002,25003,000After-tax interest income07,50007,50005,25004,500After-tax total income25,00025,00012,50016,2508,75011,37510,00011,500Interest tax shield03,7502,6251,500Cost of debt (after personal tax)15.0%15.0%10.5%9.0%Value of interest tax shield025,00025,00016,667Problem 10Target debt-equity ratio1.0Target payout ratio40%Growth rate20%Before -tax ROI21%Interest rate12%Sales-to-assets ratio1.8Tax rate35%Sustainable growth.4[{.21 + (.21 - .12)1}(1-.35)]7.8%Problem 11Hindustan Lever Ltd. (HLL)(Rs crore)YearGFANCAINVSTNWDebtNSPBITINTPAT1992330.5323.112.3333.3200.31221.1197.032.260.01993365.6285.851.0385.7115.21505.0244.927.279.81994491.8299.7191.5538.3146.51721.3327.429.597.31995563.8193.0122.8638.3160.22039.4385.220.2122.11996953.6168.9328.8937.5260.12798.8654.257.0185.219971035.2567.2544.61260.8186.63337.8874.233.9232.019981273.4895.3729.51712.4264.36560.71130.529.3404.719991349.71151.81068.12102.6177.37736.81420.122.4570.320001539.41087.11832.22487.6111.69426.11668.413.2808.220011778.31349.71668.93043.083.710116.51865.67.71079.820021836.91639.02397.73658.258.310588.22154.49.21300.3Capital structure analysisInvstments anf FinancingYearDebt ratioD/ECoverageCapex INVST NCA NW Debt199237.5%0.606.1-----199323.0%0.309.035.138.7-37.352.4-85.1199421.4%0.2711.1126.2140.513.9152.631.3199520.1%0.2519.172.0-68.7-106.7100.013.7199621.7%0.2811.5389.8206.0-24.1299.299.9199712.9%0.1525.881.6215.8398.3323.3-73.5199813.4%0.1538.6238.2184.9328.1451.677.719997.8%0.0863.476.3338.6256.5390.2-87.020004.3%0.04126.4189.7764.1-64.7385.0-65.720012.7%0.03242.3238.9-163.3262.6555.4-27.920021.6%0.02234.258.6728.8289.3615.2-25.4Profitability analysiYearNS/CEPBIT/NSPBIT/CEPAT/PBITCE/NWROE19922.316.1%36.9%30.5%1.6018.0%19933.016.3%48.9%32.6%1.3020.7%19942.519.0%47.8%29.7%1.2718.1%19952.618.9%48.2%31.7%1.2519.1%19962.323.4%54.6%28.3%1.2819.8%19972.326.2%60.4%26.5%1.1518.4%19983.317.2%57.2%35.8%1.1523.6%19993.418.4%62.3%40.2%1.0827.1%20003.617.7%64.2%48.4%1.0432.5%20013.218.4%59.7%57.9%1.0335.5%20022.820.3%58.0%60.4%1.0235.5%Problem 12Philips India Ltd.(Rs crore)YearGFANCAINVSTNWTDSTBBLTBDEBNNSPAT1990154.782.12.141.3116.512.1104.456.7391.2-8.21991162.197.17.663.6101.816.085.848.3523.126.71992181.8122.912.276.5114.631.183.641.2689.521.51993232.1112.813.8129.369.36.452.922.8672.09.01994253.1141.313.2175.962.512.839.63.21092.733.71995319.2223.414.7187.4169.791.363.43.01454.422.11996376.1194.319.6190.9186.971.5100.332.71438.811.81997386.0175.816.7171.7168.347.680.732.71509.444.61998414.8217.815.5176.2195.744.8110.972.21620.139.21999330.4213.114.0191.6159.935.4104.550.01662.941.42000363.3134.114.0167.8127.325.886.553.81444.4-3.12001334.740.017.3147.366.145.920.20.01459.540.42002605.467.61.9306.448.05.542.58.31492.885.5Percentage of Capital EmployedYearNS/CEPAT/NSROETDSTBBLTBDEBN19902.48-2.1%-19.9%73.8%7.7%66.2%35.9%19913.165.1%42.0%61.5%9.7%51.9%29.2%19923.613.1%28.1%60.0%16.3%43.7%21.6%19933.381.3%7.0%34.9%3.2%26.6%11.5%19944.583.1%19.2%26.2%5.4%16.6%1.3%19954.071.5%11.8%47.5%25.6%17.8%0.8%19963.810.8%6.2%49.5%18.9%26.5%8.7%19974.443.0%26.0%49.5%14.0%23.7%9.6%19984.362.4%22.2%52.6%12.0%29.8%19.4%19994.732.5%21.6%45.5%10.1%29.7%14.2%20004.89-0.2%-1.8%43.1%8.7%29.3%18.2%20016.842.8%27.4%31.0%21.5%9.5%0.0%20024.215.7%27.9%13.5%1.6%12.0%2.3%