1. Exercise on Unit 2 – Theories of Capital Structure
1. Companies U & L are identical in all respect except that U is unlevered while L is levered.
Company L has Rs. 20 Lacs of 8% debentures outstanding. Assume
a. All MM assumptions are met
b. Tax rate is 35%
c. EBIT is Rs. 6 Lacs
d. Equity capitalization rate of company U is 10%
Find the following:
a. Value of each firm according to MM approach
b. Suppose Value of U is Rs. 25 Lacs and Value of L Rs. 35 Lacs. According to MM approach,
do they represent equilibrium values? If not explain the process by which equilibrium will be
restored.
2. A company wishes to determine its optimum capital structure. From the following information
determine the optimum capital structure of the company.
Situation Debt Equity After tax cost of Ke(%)
debt
1 400000 100000 9 10
2 250000 250000 6 11
3 100000 400000 5 14
3. Given EBIT of Rs. 200000, corporate tax rate of 35% and following data determine the amount of
debt that should be used by the firm in its capital structure to maximise the value of the firm:
Debt Kd(before Tax) % Ke(%)
Nil Nil 12
100000 10 12
200000 10.5 12.6
300000 11 13
400000 12 13.6
500000 14 15.6
600000 17 20
4. Company X and Y are in the same risk class and are identical in every respect except that
company X uses debt while company Y does not. The levered firm has Rs. 9,00,000 10%
debentures. Both the firms earn 20% operating profit on their total assets of Rs. 15 Lacs.
Assume perfect capital market, rational investors, tax rate of 35% and capitalization rate of
15% for an all equity company.
a. Compute value of firm X and Y using Net Income Approach
b. Compute value of firm X and Y using Net operating Income Approach
c. Using NOI approach, calculate the overall cost of capital of firm X and Y
d. Which one has an optimum capital structure according to NOI approach.
5. The company’s current operating income is Rs. 4 lakhs. The firm has Rs. 10 lakhs of 10%
debt outstanding. Its cost of equity capital is estimated to be 15%.

2. a) Determine the current value of the firm using the traditional valuation approach.
b) Calculate the firm’s overall capitalization rate.
c) The firm is considering to increase its leverage by raising an additional Rs.
5,00,000/- debt & using the proceeds to retire that amount of equity. As a result of
increased financial risk, the Kd is likely to go up to 12% & Ke to 18%. Would you
recommend the plan?
6. X Co. has an operating net income of Rs. 200000 on an investment of Rs. 10,00,000 in
assets. It can raise debt at a 16% rate of interest. Assume that taxes do not exist.
a. Using the NI approach and an equity capitalization rate of 18%, compute the total
value of the firm and the weighted average cost of capital if the firm has (i) no debt,
(ii) Rs. 3,00,000 debt, (iii) Rs. 6,00,000 debt
b. Using the NOI approach and an overall capitalization rate of 12%, compute the
total value of the firm, value of shares and the cost of equity if the firm has (i) no
debt, (ii) Rs. 3,00,000 debt, (iii) Rs. 6,00,000 debt