1. Two companies April Ltd. and May Ltd. belong to the same risk class and are identical in every fashion except that April uses debt while May does not. The levered company has Rs.7, 00,000 debentures carrying 12% rate of interest. Both the firms earn 18% before interest and taxes on their total assets of Rs.20 lakh. Assume perfect capital markets, rational investors and so on. Both companies pay tax at 40%. Capitalization rate for an all equity company is 16%.

You are required to

a. Compute the value of the two firms using the net income and Modigiliani and Miller approach.

b. Using the MM approach, compute the overall capitalization rate for both the companies.

c. Identify which of the two companies has an optimal capital structure according to the MM approach; give reasons for your answer

2. There are two firms Alpha and Beta similar in all respects except in the degree of leverage employed by them. From the financial data given below, you are required to calculate the average cost of capital for both the firms as per the Net Income approach. (coc= 10%, 9.12%)

Alpha Beta

Net operating income 20,000 20,000

Interest on debt 0 4,500

Equity earnings 20,000 15,500 Cost of debt capital 7% 7%

Cost of equity capital 10% 10%

Market value of equity 2,00,000 1,55,000

Market value of debt 0 64,286

Total value of the firm 2,00,000 2,19,286

3. A company's expected annual net operating income (EBIT) is Rs.75,000. The company has 1,50,000, 10% debentures. The equity capitalization rate of the company is 12%. Assuming that there are no taxes you are required to calculate the value of the firm as well as the total cost of capital. (Rs.6.5 lacs,11.53%)

4. ABC Ltd. and XYZ Ltd. are in the same risk class and are similar in every respect except that ABC Ltd. is a levered firm, while XYZ Ltd. is unlevered. ABC Ltd. has Rs.12,00,000 debentures worth carrying 12% rate of interest. Both the firms earn 18% before interest and taxes on their total assets of Rs.22 lakh. Assume a tax rate of 50% and a capitalization rate of 14% for the unlevered firm. Calculate the value of both the firms using Net Income approach.(30,00,000 and 28,28751)

5. Phoenix Ltd. has a net operating income of Rs 40 million, Phoenix employs Rs.90 million debt capital carrying 8% percent interest charge. The equity capitalization rate applicable to Phoenix is 16%. What is the market value of Phoenix under the net income method? Assume that there is no tax. (Rs.2950 lacs)

6. The following information is available for two firms, Star Ltd and Moon Ltd

Star Ltd. Moon Ltd. Net operating income 15,00,000 15,00,000 Interest on debt Nil 6,00,000 Cost of equity 16% 16% Cost of debt 12% 12%

a. Calculate the market value of equity, market value of debt and total value of both the firms. b. What is the average cost of capital for each of the firms? c. What happens to the average cost of capital of Star Ltd. if it employs Rs.20 million of debt to finance

a project that yields an operating income of Rs.4 million? d. What happens to average cost of capital of Moon Ltd. if it sells Rs.3 million of additional equity (at

par) to retire Rs.3 million of outstanding debt? In answering the above questions assume that the Net Income approach applies and there are no taxes.

7. The management of Stellar Company, subscribing to the net operating income approach, believes that its cost of debt and overall cost of capital will remain at 10% and 14% respectively. If the equity shareholders demanded a return of 22%, what should be the proportion of debt and equity in the firm’s capital structure? Assume that there are no taxes. (2:1)

8. Two firms Delta Ltd. and Sigma Ltd. are similar in all respects except the degree of leverage employed by them. From the data given below, calculate the equity capitalization rates for the firms. (14.8%, 16.2%)

Delta Ltd. Sigma Ltd.

Net operating income 15,000 15,000

Overall capitalization rate 0.14 0.14

Total market value 1,07,143 1,07,143

Interest on debt 2,500 5,000

Debt capitalization rate 0.11 0.11

Market value of debt 22,727 45,455

Market value of equity 84,416 61,688

Degree of leverage 0.269 0.736 9. X Ltd operates in the electrical spares industry. The income statement of the company is given below:(Rs. in Lacs)Net operating income: Rs. 40 lacsInterest : Rs. 12 lacsEarnings for equity shareholders: Rs. 28 lacsThe capitalization rate for debt is 10% and the overall capitalization rate for the entire firm is 12.5%. If other things remain the same, then what is the maximum amount of funds that the firm can borrow in terms of market value so that its equity capitalization rate does not exceed 16%? Assume M-M model.

10. The management of a firm believes that the cost of equity and debt for different proportions of equity and debt in the capital structure are as follows:

Proportion of equity

Proportion of debt Cost of equity Ke %

Cost of debt Kd%

1.00 0.00 10 5 0.90 0.10 10 5.5 0.80 0.20 10.5 6 0.70 0.30 11 6.5 0.60 0.40 11.5 7 0.50 0.50 12 8 0.40 0.60 13 8.5 0.30 0.70 14 9 0.20 0.80 15 9.5 0.10 0.90 18 10 What is the optimum capital structure of the firm?