Chapter 15: Capital Structure Theory and Policy

Problem 1
NI approach:
Investment
Debt
Interest rate
Equity-capitalisation rate, ke

No debt
1,000,000
0
16%
18%

300,000 debt
1,000,000
300,000
16%
18%

600,000 debt
1,000,000
600,000
16%
18%

NOI
Interest (16%)
NI
Market value of equity, E =NI/ke
Market value of debt, D
Value of the firm, V +E + D
WACC, NOI/V

200,000
0
200,000
1,111,111
0
1,111,111
18.0%

200,000
48,000
152,000
844,444
300,000
1,144,444
17.5%

200,000
96,000
104,000
577,778
600,000
1,177,778
17.0%

NOI approach:
Investment
Debt
Interest rate
Over-all capitalisation rate, ko

No debt
1,000,000
0
16.00%
12.00%

300,000 debt
1,000,000
300,000
16.00%
12.00%

600,000 debt
1,000,000
600,000
16.00%
12.00%

NOI
Interest
NI
Value of the firm, V = NOI/ko
Market value of debt, D
Market value of equity, E = V - D
Cost of equity, ke = NI/E

200,000
0
200,000
1,666,667
0
1,666,667
12.0%

200,000
48,000
152,000
1,666,667
300,000
1,366,667
11.1%

200,000
96,000
104,000
1,666,667
600,000
1,066,667
9.8%

Problem 2
Assets
Debentures
ROI
Cost of debt
Corporate tax rate
Pure equity-capitalisation rate
NOI approach:
NOI
Tax
After-tax NOI
Value of the firm, V
WACC, After-tax NOI/V
NI approach:
NOI
Interest
PBT
Tax
NI
Interest tax shield
Value of equity, E = V - D
Value of debt, D
Value of the firm, V

U
800,000
0
18%
0%
50%
15%

L
800,000
400,000
18%
12%
50%
15%

144,000
72,000
72,000
480,000
15.0%

144,000
72,000
72,000
480,000
15.0%

144,000
0
144,000
72,000
72,000
0
480,000
0
480,000

144,000
48,000
96,000
48,000
48,000
24,000
320,000
400,000
720,000

Arbitrage:
Investment in L's shares
Investment value: 5% x 320,000
Return from the investment: 5% x 48,000
Sell shares in L (cash inflow)
Borrow equal to 5% of U's debt:
5% x (1-0.50) x 400,000
Total available cash
Buy 5% of U's shares: 5% x 480,000
Remaining cash
Return:
Return from U's shares: 5% x 72,000
Less: cost of borrowed funds: 10,000 x 12%
Net return

5%
16,000
2,400
16,000
10,000
26,000
24,000
2,000
3,600
1,200
2,400

Problem 3

NOI
Interest
Net income
Value of equity, E
Value of Debt, D
Value of firm, V
Cost of equity, ke
Cost of debt, kd
Cost of capital, k0
Corporate leverage: D/E

X
200,000
0
200,000
1,800,000
0
1,800,000
11.10%
0.00%
11.10%
0.00%

Y
200,000
36,000
164,000
1,312,000
600,000
1,912,000
12.50%
6.00%
10.50%
45.73%

Percentage shares held in Y: (20/1312)

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

1.52%
20,000.00
2,500.00

Sell shares in the levered firm Y

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

20,000.00
9,146.34
29,146.34

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

1,800,000

27,439.02

Return: (20/1312) x 200,000

Less: interest on personal debt: 9,146.34 x 6%
Net return
Surplus cash available: 29,146.34 - 27,439.02

3,048.78
548.78
2,500.00
1,707.32

Problem 4

NOI
Interest
NI
Equity-capitalisation rate, ke
Value of shares, E
Value of debt, D
Value of the firm, V
Overall capitalisation rate

A
150,000
0
150,000
10%
1,500,000
0
1,500,000
10.0%

B
150,000
30,000
120,000
15%
800,000
500,000
1,300,000
11.5%

Investment in A's shares

Investment value
Return

10%
150,000
15,000

Sell share in A

150,000

Buy shares in B
Lend at 6% in firm B
Investment
Surplus cash

80,000
50,000
130,000
20,000

Return
12,000
3,000
15,000

Problem 5

Value of shares, E
Value of debt, D
Value of the firm, V
Cost of debt, kd
NOI
Interest
NI
Cost of equity, ke = NI/E
WACC, k0 = NOI/V

Unlevered Levered (L)

(U)
500,000
280,000
0
250,000
500,000
530,000
0%
6%
50,000
0
50,000
10.0%
10.0%

50,000
15,000
35,000
12.5%
9.4%

Investment in L's shares

Investment value: 5% x 280,000
Return: 5% x 35,000

5.00%
14,000
1,750

Sell shares in the levered firm

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

14,000
12,500
26,500

Invest in U's shares (5%)

Return: 5% x 50,000
Less: interest on debt: 6% x 12,500
Net return
Surplus cash

25,000
2,500
750
1,750
1,500

Problem 6
Traditional approach
Debt ratio
0.0%
10.0%
20.0%
30.0%
40.0%
50.0%
60.0%
M-M approach:
Debt ratio
0.0%
10.0%
20.0%
30.0%
40.0%
50.0%
60.0%

kd

ke
0.0%
5.0%
5.0%
6.0%
7.0%
8.0%
10.0%

kd

ke
0.0%
5.0%
5.0%
6.0%
7.0%
8.0%
10.0%

Problem 7

Expected NOI
Cost of debt, INT = kd x D
Net income, NI
Cost of equity, ke
Value of shares, E
Value of debt, D
Value of the firm, V = E + D
Average cost of capital, ko = NOI/V
D/E ratio

X
50,000
0
50,000
10.0%
500,000
0
500,000
10.0%
0.0%

Y
50,000
10,000
40,000
11.1%
360,000
200,000
560,000
8.9%
55.6%

Cost of capital, ko - MM thesis (given)

Value of the firm, V - MM thesis:
NOI/k
Value oof debt, D
Value of shares, E = V - D

12.5%
400,000
0
400,000

12.5%
400,000
200,000
200,000

12.5%
13.0%
13.6%
14.3%
16.0%
18.0%
20.0%

k0
12.5%
12.2%
11.9%
11.8%
12.4%
13.0%
14.0%

12.5%
13.3%
14.4%
15.3%
16.2%
17.0%
16.3%

k0
12.5%
12.5%
12.5%
12.5%
12.5%
12.5%
12.5%

Problem 8

NOI
Interest, INT
NI
Overall capitalisation rate, ko
Value of the firm, V = NOI/ko
Value of debt, D
Value of shares, E = V - D
Cost of debt, kd = INT/D
Cost of equity, ke = NI/S
Traditional view:
Cost of equity, ke
Value of shares, E = NI/ke
Value of debt, D = INT/kd
Value of the firm, V = E + D
Overall capitalisation rate,
ko = ke x (S/V) + kd x (D/V)

M
12,000
0
12,000
8%
150,000
0
150,000
0.0%
8.0%

N
12,000
2,000
10,000
8%
150,000
40,000
110,000
5.0%
9.1%

10.0%
120,000.0
0
120,000.0

10.5%
95,238.1
40,000.00
135,238.1

10.0%

8.9%

Problem 9
I
Corporate tax
Personal tax- dividend
Personal tax- interest
Equity
Debt
Cost of debt
NOI
Interest
Taxable income
Corporate tax
Net income
Invesors' net income:
Dividend income
Tax on dividend
After-tax dividend income
Interest income
Tax on interest income
After-tax interest income
After-tax total income

0%
0%
0%

0%
0%
0%

II
50%
0%
0%

50%
0%
0%

III
50%
30%
30%

U
100,000
0
0%

L
50,000
50,000
15%

U
100,000
0
0%

L
50,000
50,000
15%

U
100,000
0
0%

L
50,000
50,000
15%

25,000
0
25,000
0
25,000

25,000
7,500
17,500
0
17,500

25,000
0
25,000
12,500
12,500

25,000
7,500
17,500
8,750
8,750

25,000
0
25,000
12,500
12,500

25,000
7,500
17,500
8,750
8,750

25,000
0
25,000
12,500
12,500

25,000
7,500
17,500
8,750
8,750

25,000
0
25,000
0
0
0
25,000

17,500
0
17,500
7,500
0
7,500
25,000

12,500
0
12,500
0
0
0
12,500

8,750
0
8,750
7,500
0
7,500
16,250

12,500
3,750
8,750
0
0
0
8,750

8,750
2,625
6,125
7,500
2,250
5,250
11,375

12,500
2,500
10,000
0
0
0
10,000

8,750
1,750
7,000
7,500
3,000
4,500
11,500

50%
30%
30%

IV
50%
50%
20%
20%
40%
40%
U
L
100,000 50,000
0 50,000
0%
15%

Interest tax shield

Cost of debt (after personal tax)
Value of interest tax shield

0
15.0%
0

3,750
15.0%
25,000

2,625
10.5%
25,000

1,500
9.0%
16,667

Problem 10
Target debt-equity ratio
Target payout ratio
Growth rate
Before -tax ROI
Interest rate
Sales-to-assets ratio
Tax rate
Sustainable growth
.4[{.21 + (.21 - .12)1}(1-.35)]

1.0
40%
20%
21%
12%
1.8
35%
7.8%

Problem 11
Hindustan Lever Ltd. (HLL)
Year
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002

GFA
330.5
365.6
491.8
563.8
953.6
1035.2
1273.4
1349.7
1539.4
1778.3
1836.9

NCA
323.1
285.8
299.7
193.0
168.9
567.2
895.3
1151.8
1087.1
1349.7
1639.0

INVST
12.3
51.0
191.5
122.8
328.8
544.6
729.5
1068.1
1832.2
1668.9
2397.7

NW
333.3
385.7
538.3
638.3
937.5
1260.8
1712.4
2102.6
2487.6
3043.0
3658.2

Capital structure analysis

Year
Debt ratio
D/E Coverage
1992
37.5%
0.60
6.1
1993
23.0%
0.30
9.0
1994
21.4%
0.27
11.1
1995
20.1%
0.25
19.1
1996
21.7%
0.28
11.5
1997
12.9%
0.15
25.8
1998
13.4%
0.15
38.6
1999
7.8%
0.08
63.4
2000
4.3%
0.04
126.4
2001
2.7%
0.03
242.3
2002
1.6%
0.02
234.2

Capex
35.1
126.2
72.0
389.8
81.6
238.2
76.3
189.7
238.9
58.6

Debt
200.3
115.2
146.5
160.2
260.1
186.6
264.3
177.3
111.6
83.7
58.3

NS
1221.1
1505.0
1721.3
2039.4
2798.8
3337.8
6560.7
7736.8
9426.1
10116.5
10588.2

PBIT
197.0
244.9
327.4
385.2
654.2
874.2
1130.5
1420.1
1668.4
1865.6
2154.4

INT
32.2
27.2
29.5
20.2
57.0
33.9
29.3
22.4
13.2
7.7
9.2

Invstments anf Financing

INVST
NCA NW
38.7
-37.3
52.4
140.5
13.9
152.6
-68.7
-106.7
100.0
206.0
-24.1
299.2
215.8
398.3
323.3
184.9
328.1
451.6
338.6
256.5
390.2
764.1
-64.7
385.0
-163.3
262.6
555.4
728.8
289.3
615.2

Debt
-85.1
31.3
13.7
99.9
-73.5
77.7
-87.0
-65.7
-27.9
-25.4

(Rs crore)
PAT
60.0
79.8
97.3
122.1
185.2
232.0
404.7
570.3
808.2
1079.8
1300.3

Profitability analysi
Year
NS/CE
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002

PBIT/NS
2.3
3.0
2.5
2.6
2.3
2.3
3.3
3.4
3.6
3.2
2.8

16.1%
16.3%
19.0%
18.9%
23.4%
26.2%
17.2%
18.4%
17.7%
18.4%
20.3%

PBIT/CE PAT/PBIT CE/NW

ROE
36.9%
30.5%
1.60
18.0%
48.9%
32.6%
1.30
20.7%
47.8%
29.7%
1.27
18.1%
48.2%
31.7%
1.25
19.1%
54.6%
28.3%
1.28
19.8%
60.4%
26.5%
1.15
18.4%
57.2%
35.8%
1.15
23.6%
62.3%
40.2%
1.08
27.1%
64.2%
48.4%
1.04
32.5%
59.7%
57.9%
1.03
35.5%
58.0%
60.4%
1.02
35.5%

Problem 12
Philips India Ltd.
Year
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002

GFA
154.7
162.1
181.8
232.1
253.1
319.2
376.1
386.0
414.8
330.4
363.3
334.7
605.4

Year
NS/CE
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999

NCA
82.1
97.1
122.9
112.8
141.3
223.4
194.3
175.8
217.8
213.1
134.1
40.0
67.6

PAT/NS
2.48
3.16
3.61
3.38
4.58
4.07
3.81
4.44
4.36
4.73

-2.1%
5.1%
3.1%
1.3%
3.1%
1.5%
0.8%
3.0%
2.4%
2.5%

INVST
2.1
7.6
12.2
13.8
13.2
14.7
19.6
16.7
15.5
14.0
14.0
17.3
1.9

NW
41.3
63.6
76.5
129.3
175.9
187.4
190.9
171.7
176.2
191.6
167.8
147.3
306.4

TD
116.5
101.8
114.6
69.3
62.5
169.7
186.9
168.3
195.7
159.9
127.3
66.1
48.0

STBB
12.1
16.0
31.1
6.4
12.8
91.3
71.5
47.6
44.8
35.4
25.8
45.9
5.5

LTB
DEBN
104.4
56.7
85.8
48.3
83.6
41.2
52.9
22.8
39.6
3.2
63.4
3.0
100.3
32.7
80.7
32.7
110.9
72.2
104.5
50.0
86.5
53.8
20.2
0.0
42.5
8.3

Percentage of Capital Employed

ROE
TD
STBB
LTB
DEBN
-19.9%
73.8%
7.7%
66.2% 35.9%
42.0%
61.5%
9.7%
51.9% 29.2%
28.1%
60.0%
16.3%
43.7% 21.6%
7.0%
34.9%
3.2%
26.6% 11.5%
19.2%
26.2%
5.4%
16.6%
1.3%
11.8%
47.5%
25.6%
17.8%
0.8%
6.2%
49.5%
18.9%
26.5%
8.7%
26.0%
49.5%
14.0%
23.7%
9.6%
22.2%
52.6%
12.0%
29.8% 19.4%
21.6%
45.5%
10.1%
29.7% 14.2%

NS
391.2
523.1
689.5
672.0
1092.7
1454.4
1438.8
1509.4
1620.1
1662.9
1444.4
1459.5
1492.8

(Rs crore)
PAT
-8.2
26.7
21.5
9.0
33.7
22.1
11.8
44.6
39.2
41.4
-3.1
40.4
85.5

2000
2001
2002

4.89
6.84
4.21

-0.2%
2.8%
5.7%

-1.8%
27.4%
27.9%

43.1%
31.0%
13.5%

8.7%
21.5%
1.6%

29.3%
9.5%
12.0%

18.2%
0.0%
2.3%