T H E O RY O F C A P I TA L S T R U C T U R E Chapter 8 39

Illustrative Problems
ILLUSTRATION 1. The MM Company has net operating earnings of Rs 20,000 and Rs 30,000 of debt
with a 10 percent interest charge. Assume the absence of taxes.
a. Using the net income approach and an equity capitalization rate of 12 percent, compute the total
value of the firm and the implied overall capitalization rate.
b. Assume that the firm issues an additional Rs 20,000 in debt and uses the proceeds to retire stock; the
interest rate and equity capitalization rate remains the same. Compute the new total value of the firm
and overall capitalization rate.
c. Using the net operating income approach and an overall capitalization rate of 11 percent, compute
the total market value, the stock market value, and the implied equity capitalization rate for the MM
Company before and after the sale of additional debt.
SOLUTION
a. Total value of the firm and implied overall capitalization rate using the net income approach.
First calculate the value of the stock (S)
We have,
S = = = = = 141,667
Total market value of the firm (V) = B + S
= Rs. 30,000 + Rs 141,667 = Rs 171,667
Overall capitalization rate (k) = = = 0.1165 or 11.65%
b. Total value of the firm and implied overall capitalization rate using the net income approach with
additional Rs 20,000 in debt.
S = = = 125,000
Total market value of the firm (V) = B + S = Rs. 50,000 + Rs 125,000 = Rs 175,000
Overall capitalization rate (k) == = 0.1143 or 11.43%
c. Total value of the firm and implied overall capitalization rate using the net income approach.
Before the sale of additional debt
Total market value of the firm (V) = = = Rs 181,818
Total market value of the stock (S) = V B = Rs 181,818 30,000 = Rs 151,818
Cost of equity (ks) = = = 0.1120 or, 11.20%
After the sale of additional debt
Total market value of the firm (V) = = = Rs 181,818
Total market value of the stock (S) = V B = Rs 181,818 50,000 = Rs 131,818
Cost of equity (ks) = = = 0.1138 or, 11.38%
ILLUSTRATION 2. XYZ Company has employed debt capital of Rs 6 million paying interest rate of 5
percent and expected operating earnings (EBIT) amounted to Rs 2 million per year. The companys cost of
capital is assumed to be constant at 10 percent. Given these information, (a) calculate the firms market
value, value of the firms common stock, cost of the firms equity and debt equity ratio using Net
Operating Income Approach (NOI) (b) If debt increases from Rs 6 million to Rs 10 million, calculate the
value of the firm, value of the common stock, cost of equity, and debt equity ratio. Why the value of the
firm does not change despite increase in debt?
SOLUTION
Given,
Amount of debt (B) = Rs 6 million
Interest rate (i) = 5%
EBIT = Rs 2 million
Cost of capital (k) = 10%
a. Firms market value (V) =?
Value of the firm (V) = = = Rs 20,000,000
Value of the firms common stock (S) = ?
Value of equity = V B = Rs 20,000,000 Rs 6,000,000 = Rs 14,000,000
Cost of equity (ks) =?
Cost of equity (ks) = = = 0.1214 or 12.14%
40 Chapter 8 C A P I TA L STRUCTURE MANAGEMENT
Working notes:
Net operating income Rs 2,000,000
Less: Interest on debt (5%) 300,000
Earnings to common stockholders Rs 1,700,000
Debt-equity ratio =?
Debt equity ratio = = = 0.4286 or, 42.86%
b. Given, Amount of debt (B) = Rs 10 million
Firms market value (V) = ?
Value of the firm (V) = = = Rs 20,000,000
Value of the firms common stock (S) = ?
Value of equity = Value of firm Value of debt
= Rs 20,000,000 Rs 10,000,000 = Rs 10,000,000
Cost of equity (ks) = ?
Cost of equity (ks) = = = 0.15 or 15%
Working notes:
Net operating income Rs 2,000,000
Less: Interest on debt (5%) 500,000
Earnings to common stockholders Rs 1,500,000
Debt-equity ratio = ?
Debt equity ratio = = = 1 Or, 100%
Since the NOI approach assumes that cost of capital remains constant regardless of changes in leverage, the
cost of capital cannot be altered through leverage. Hence this approach suggests that there is no one
optimal capital structure.
ILLUSTRATION 3. Jyoti Spinning Mill has net operating income (NOI) of Rs 5 million and pays a
coupon rate of 10 percent on all debt. Assume that there are no taxes and all debt is issued at par.
a. Under net income approach, assuming a cost of equity capital of 15 percent, compute the value of the
firm and cost of capital for (i) all equity capital structure (ii) debt of Rs 23 million and (iii) all debt
capital structure.
b. Under net operating income approach, assuming a cost of equity capital of 12.5 percent, compute the
value of the firm cost of equity capital for (i) all equity capital structure (ii) debt of Rs 23 million and
(iii) all debt capital structure.
c. Why is capital structure issue more important under net income approach and only a mere detail
under net operating income approach?
SOLUTION
Given,
Net operating income (NOI or EBIT) = Rs 5,000,000
Interest on debt (kd) = 10%
Taxes =0
a. Cost of equity (ke) =15%
Approach = Net income
(i) All equity firm
Value of the firm (V) = = = Rs 33,333,333.33
Cost of capital (WACC) = = = 0.15 or, 15%
(ii) Amount of debt is Rs 23 million
We have,
Market value of equity (S) = = = Rs 18,000,000
Working notes:
Net operating income Rs 5,000,000
Less: Interest on debt (10%) 2,300,000
Earnings to common stockholders Rs 2,700,000
Total value of the firm (V) = Value of equity + Value of debt
= Rs 18,000,000 + Rs 23,000,000
= Rs 41,000,000
Cost of capital (WACC) = = = 0.1220 or, 12.20%
(iii) All debt in capital structure

Value of the firm
Cost of capital (WACC)
b. Net operating income approach
Cost of capital (k or, WACC) = 12.5%
(i) All equity firm
Value of the firm (V)
Value of equity
Cost of equity (ks)
(ii) Amount of debt Rs 23,000,000
Value of the firm (V)
Value of equity
Cost of equity (ks)
T H E O RY O F C A P I TA L S T R U C T U R E Chapter 8 41
= Value of debt = Rs 23,000,000
= Cost of debt = 10%
= = = Rs 40,000,000
= Value of firm = Rs 40,000,000
= = = 0.125 or 12.5%
= = = Rs 40,000,000
= Value of firm Value of debt
= Rs 40,000,000 Rs 23,000,000 = Rs 17,000,000
= = = 0.1588 or 15.88%
42 Chapter 8 C A P I TA L STRUCTURE MANAGEMENT
Working notes:
Net operating income Rs 5,000,000
Less: Interest on debt (10%) 2,300,000
Earnings to common stockholders Rs 2,700,000
(iii) All debt capital structure
Value of the firm (V) = Value of debt
= Rs 23,000,000
Cost of capital = Cost of debt = 10%
Cost of equity =0%
Value of equity (S) =0
c. Capital structure issue is more important under Net Income Approach because the capital structure affect
the value of the firm. Capital structure is less important in Net Operating Income Approach because
capital structure does not affect the value of the firm.
ILLUSTRATION 4. Nepal Oil Corporation has Rs 2 million in earnings before interest and taxes.
Currently it is all equity financed. It may issue Rs 6 million in perpetual debt at 15 percent interest to
repurchase stock, thereby recapitalizing the corporation. There are no personal taxes.
a. If the corporate tax rate is 40 percent, what is the income to all security holders (1) if the company
remains all equity financed? (2) if it is recapitalized?
b. What is the present value of the debt tax shield?
c. The required return on equity for the company's stock is 20 percent while it remains all equity
financed. What is the value of the firm? What is the value if it is recapitalized?
SOLUTION
a. Income to all security holders
Particulars All equity Debt and equity
EBIT................................................................................................... Rs 2,000,000 Rs 2,000,000
Interest to debt holders....................................................................... 0 900,000
Profit before taxes............................................................................... Rs 2,000,000 Rs 1,100,000
Less: Taxes (40%).............................................................................. 800,000 440,000
Income available to common stockholders.......................................... Rs 1,200,000 Rs 660,000
Income available to all security holders (Interest + NI)........................ Rs 1,200,000 Rs 1,560,000
b. Present value of debt tax shield (BTC) = Rs 6,000,000 0.40 = Rs 2,400,000
c. Value of all equity financed firm (VU) = = = Rs 6,000,000
Value of levered firm (VL) = VU + B TC
= Rs 6,000,000 + Rs 2,400,000 = Rs 8,400,000

ILLUSTRATION 5. MM Corporation has earnings before interest and taxes of Rs 3 million and a 40
percent tax rate. Its required rate of return on equity in the absence of borrowing is 18 percent.
a. In the absence of personal taxes, what is the value of the company in an MM world (1) with no
leverage? (2) with Rs 4 million in debt? (3) with Rs 7 million in debt?
b. Personal as well as corporate taxes now exit. The marginal personal tax rate on common stock
income is 25 percent, and the marginal personal tax rate on debt income is 30 percent. Determine the
value of the company for each of the three debt alternatives in part a. Why do your answers differ?
SOLUTION
a. 1. Value if unlevered:
EBIT.............................................................................................................................................. Rs 3,000,000
Less: Interest on debt ................................................................................................................... 0
Profit before taxes......................................................................................................................... Rs 3,000,000
Less: Taxes (40%)........................................................................................................................ 1,200,000
Earnings to common..................................................................................................................... Rs 1,800,000
Value of equity firm (VU) == = Rs 10,000,000
2. Value with Rs 4 million in debt:
Value of levered firm = Value of unlevered firm + PV of debt tax shield
VL = VU + BTC
 T H E O RY O F C A P I TA L S T R U C T U R E Chapter 8 43
= Rs 10,000,000 + Rs 4,000,000 0.40
= Rs 11,600,000

3. Value with Rs 7 million in debt:

Value of levered firm = Value of unlevered firm + PV of debt tax shield
VL = VU + BTC
= Rs 10,000,000 + Rs 7,000,000 0.40 = Rs 12,800,000
Due to the tax subsidy, the firm is able to increase its value in a linear manner with more debt.

b. 1. Value if unlevered:
Value of equity firm (VU) = = = Rs 10,000,000
2. Value with Rs 4 million in debt:
Value of levered firm = Value of unlevered firm + PV of debt tax shield
VL = VU + B
= Rs 10,000,000 + Rs 4,000,000 = Rs 11,429,000
Where,
TPS = personal tax rate on stock income
TPd = personal tax rate on debt income

3. Value with Rs 7 million in debt:

Value of levered firm = Value of unlevered firm + PV of debt tax shield
VL = VU + B
= Rs 10,000,000 + Rs 7,000,000 = Rs 12,500,000
The presence of personal taxes reduces the tax advantage associated with debt. As long as the personal tax
on stock income is less than that on debt income, however, the net tax advantage to debt is positive. As a
result, the value of the firm rises with more debt, but not as rapidly as if there were no personal taxes or if
the personal tax rate on stock and debt income were the same.
ILLUSTRATION 6. You are provided the following information: The firm's expected net earnings before
interest and taxes is Rs 1200. Its value as an unlevered firm is Rs 4,000. The tax rate is 50 percent. The cost
of debt is 12 percent. The ratio of debt to equity for the levered firm, when it is levered, is 1. Use the MM
propositions to:
a. Calculate the after tax cost of equity capital for both the levered and the unlevered firm.
b. Calculate the after tax weighted average cost of capital for each.
c. Why is cost of equity capital higher for the levered firm, but the weighted average cost of capital
lower?
SOLUTION
The after tax cost of equity capital for both the levered and unlevered firm
After tax cost of equity for unlevered firm
kS = = = 0.15 Or, 15%
After tax cost of equity for levered firm
kS = kU +(kU kd)(1T)B/S
= 15 + (1512) (10.5) 1
= 15 + 3 0.5
= 16.5%
The after tax weighted average cost of capital for each
WACC of unlevered firm
WACC = = = 0.15 or 15%
WACC for levered firm
k = kd (1T) + kS
= 12 (10.5) 0.5 + 16.5 0.5
= 11.25%
According to MM Proposition, the cost of equity increases with greater financial leverage because
shareholders' are exposed to greater risk. Therefore, leverage firm has greater financial risk and higher
return on equity.
ILLUSTRATION 7. L'Etoile du Nord Resorts is considering various levels of debt. Presently, it has no
debt and a total market value of Rs 15 million. By undertaking leverage, it believes that it can achieve a net
tax advantage (corporate and personal combined) equal to 20 percent of the amount of the debt. However,
44 Chapter 8 C A P I TA L S T R U C T U R E M A N A G E M E N T
the company is concerned with bankruptcy and agency costs as well as lenders increasing their interest
rate if it borrows too much. The company believes that it can borrow up to Rs 5 million without incurring
any of these costs. However, each additional Rs 5 million increments in borrowing is expected to result in
the three costs cited being incurred. Moreover, they are expected to increase at an increasing rate with
leverage. The present-value cost is expected to be the following for various levels of debt:
Debt (in millions) Rs 5 Rs 10 Rs 15 Rs 20 Rs 25 Rs 30
PV cost of bankruptcy, agency, and
0 0.6 1.2 2.0 3.2 5.0
increased interest rate (in millions)
Is there an optimal amount of debt for the company?
SOLUTION

Firm value PV of debt tax PV of bankruptcy, Agency,

Level of debt Value of the firm*
unlevered shield ( B T) and Increased interest cost
0 Rs 15,000,000 0 0 Rs 15,000,000
Rs 5,000,000 15,000,000 Rs 1,000,000 0 16,000,000
10,000,000 15,000,000 2,000,000 Rs 600,000 16,400,000
15,000,000 15,000,000 3,000,000 1,200,000 16,800,000
20,000,000 15,000,000 4,000,000 2,000,000 17,000,000
25,000,000 15,000,000 5,000,000 3,200,000 16,800,000
30,000,000 15,000,000 6,000,000 5,000,000 16,000,000
* Value of the firm = Value of unlevered firm + PV of debt tax shield - PV of bankruptcy, agency, and Increased interest
cost
The market value of the firm is maximized with Rs 20,000,000 in debt.

PROBLEM 1. Delta Company and Gamma Company are identical except for capital structures.
Net Operating Income Delta has 50 percent debt and 50 percent equity, whereas Gamma has 20 percent
Approach debt and 80 percent equity. (All percentages are in market-value terms.) The
borrowing rate for both companies is 8 percent in a no-tax world, and capital
markets are assumed to be perfect.
a. (1) If you own 2 percent of the stock of Delta , what is your rupee return if the
company has net operating income of Rs 360,000 and the overall capitalization
rate of the company is 18 percent? (2) What is the implied required rate of
return on equity?
b. Gamma has the same net operating income as Delta. (1) What is the implied
required equity return of Gamma? (2) Why does it differ from that of Delta?
PROBLEM 2. Humla Papers Industries is financed equity entirely with 100,000 shares of common
NI and NOI Approach stock selling at Rs 50 per share. The firms EBIT is expected to be Rs 400,000. The
with and without taxes firm pays 100 percent of its earnings as dividends. Ignore taxes.
a. Using the NI approach, compute the total value and cost of equity.
b. The company has decided to retire Rs 1 million of common stock, replacing it
with 9 percent long term debt. Compute the total value of the firm and the
overall cost of capital after refinancing.
c. Using the NOI approach and an overall cost of capital of 10 percent, compute
the total value, the stock market value of the firm, and the cost of equity.
d. Recalculate part c if the company decided to retire Rs 1 million of common
stock, replacing it with 9 percent long term debt.