Business Finance Long Answer Type Questions
Question 1.
Explain various Long Term Sources of Finance.
OR
Explain in detail long term sources of raising capital.
Answer:
The various sources of finance have been classified as follows:
(A) Security/External Financing: Corporate securities can be classified under two categories:
- Ownership Securities or Capital Stock
- Creditorship securities or Debt Capital
(i) The term Ownership securities represents shares. Shares are the most universal form of raising long term funds from the market. The capital of a company is’ divided into a number of equal parts known as shares. Companies issue different types of shares to mop up funds from investors. The various kinds of shares are discussed as follows:
(a) Equity Shares: Equity shares are also known as ordinary shares or common shares and represent the owners capital in a company. The holders of these shares are the real owners of the company. They control the working of the company. The rate of dividend on these shares depends upon the profits of the company. Equity capital is paid after meeting all other claims including that of preference shareholders. Equity share capital cannot be redeemed during the lifetime of the company.
Public Issue of Equity means raising of share capital directly from the public. As per the existing norms, a company with a track record is free to determine the issue price for its shares. Thus, it can issue shares at a premium. However, a new company has to issue its shares at par.
Private Placement involves sale of shares by a company to few selected investors, particularly the institutional investors like UTI, LIC and IDBI.
Rights issue involves selling of ordinary shares to the existing shareholders of the company. Law in India requires that new ordinary shares must be first issued to existing shareholders on a pro-rata basis. This pre-emptive right can be forfeited by shareholders through a special resolution.
(b) Preference Shares: These shares have certain preferences as compared to other types of shares. There is a preference for payment of dividend and there is a preference for repayment of capital at the time of liquidation of the company. A fixed rate of dividend is paid on preference share capital. Preference shareholders do not have any voting rights and hence they have no say in the management of the company. However, they can vote if their own interests are affected.
(c) Deferred Shares: Also known as Founders Shares, these shares were earlier issued to promoters or founders for services rendered to the company. These shares rank last so far as payment of dividend and repayment of capital is concerned. These shares are generally of a small denomination.
(ii) Creditorship Securities, also known as ‘debt capital’, represents debentures and bonds. A debenture is an acknowledgement of a debt. It is a long-term promissory note for raising loan capital. A debenture or bondholder is a creditor of the company. A fixed rate of interest is paid on debentures. The debentures are generally given a floating Charge over the assets of the company. They are paid on priority in comparison to all other creditors.
(B) Internal Financing
(i) Retained Earnings is a technique of financial management under which all profits of a company are not distributed amongst the shareholders as dividend but a part of the profits is retained in the company. This is also known as ploughing back of profits. A part of the profits is ploughed back or re-employed into the business and is regarded as an ideal source of financing expansion and modernisation schemes as there is no immediate pressure to pay a- return on this portion of stockholders equity. A part of total profits is transferred to reserves such as General Reserve, Reserve Fund, Replacement Fund etc.
(ii) Depreciation as a source of funds Depreciation may be regarded as the capital cost of assets allocated over the life of the asset. It is a gradual decrease in the value of asset due to wear and tear, use and passage of time. In reality depreciation is simply a book entry having the effect of reducing the book value of the asset and profits of the current year for the same amount.
It is a non fund item. Hence, although depreciation is an operating cost there is no actual outflow of cash and so the amount of depreciation charged during the year is added back to profits while finding funds from operations. It is an indirect source of fund as it helps a concern to effect savings in taxes and dividends. However this is true only if the concern is making profits.
Question 2.
Explain the factors influencing the determination of the capital structure of a company.
Answer:
The following factors have practical implications for-capital structure of a business enterprise.
Control: The management control over the firm is one of the major determinants of capital structure decisions. The equity shareholders are considered as the real owners of the company, since they can participate in the decision making through the BOD. Preference shareholders and debentures holders cannot participate in decision making.
Risk: Risk and return always go hand in hand. Business risks are influenced by demand price, input costs, fixed costs, business cycles, competition etc. The business risk of a firm is determined by the accumulated investments the firm makes over time. A firm with high business risk prefer to have low levels of debt, since the volatility of its earnings is-more. A firm with low level of business risk can have higher debt component in capital structure, since the risk of variations in expected earnings is lower.
Income: Increase of return on equity shareholders depends on the method of financing and its impact on EPS and ROE. If the levels of EBIT is low from EPS point of view, equity is preferable to debt. If the EBIT is high from EPS point of view, debt financing is preferable. IF the ROI is less than the cost’ of debt, financial leverage depress ROE. When the ROI is more than cost of debt, financial leverage enhances ROE.
Tax Consideration: Under the provisions of the IT Act,, the dividend payable on equity capital and preference capital is not tax deductible, causing the high cost of such funds. Interest paid on debt is deductible from income and reduces a firm’s tax liabilities. The tax saving on interest charges reduces the cost of debt funds, Debt, thus, has tax advantage over equity.
Cost of capital: Cost of different components of capital will influence the capital structuring decisions. A firm should possess earning power to generate revenues to meet its cost of capital and finance its future growth. The cost of debt funds are cheaper as compared to cost of equity funds due to tax advantage. . But increased gearing causes the increase in expectations of debt providers for accepting more risk.
Trading on Equity: The basic objective of financial management is to enhance the wealth of the firm by increasing the market value of the share. The firm’s wealth is increased, if after tax earnings are increased. A company raises debt at low cost with a view to enhance the earnings of the equity shareholders.
Investors attitude: In a segmented market, different sets of investors measure risk differently or by simply charging different rates on the capital that they invest. By. choosing the instrument that taps the cheapest market, firms lower their cost of capital.
Flexibility: Debt capital has got the characteristic of greater flexibility than equity capital and this influences the capital structure decisions. As and when required, debt may be raised and it can be paid off as and when desired.
But in case of equity, once the funds are raised through the issue of equity shares, it cannot ordinarily be reduced except with the permission of the court and compliance with a lot of legal obligations.
Market conditions: In times of boom, it is easier to raise equity, but in times of recession, the equity investors will not show much interest and the firm has to rely on debt funds.
Legal Provisions: Raising of equity capital is mote complicated than raising debt.
Profitability: A company with higher profitability will have low reliance on outside debt and it will meet its additional requirements through internal, generation.
Growth Rate:Fast growing companies reply more on debt than on equity.
Government policy: Monetary and fiscal policies of the government also affect capital structure decisions.
marketability: The company’s ability to market its securities will affect the capital structure decisions.
Company size: Companies with small capital base rely more on owner’s funds and internal earnings.
Purpose of financing: Long term projects are financed through long term sources and in the form of equity. Short term projects are financed by issue of debt instruments and by raising of term loans from banks and financial institutions.
Question 3.
Explain two different theories or approaches of capital structure.
Answer:
As far as the concept of capital structure is concerned a number of eminent scholars have made th^ir respective contributions. Few among them are David Durand, Ezra Solomon, Modigliani and Miller etc.
According to David Durand who has rightly said that there cannot be an optimal capital structure. He classifies the theory of capital structure into two extreme views. They are: (a) Net income approach (b) Net operating income approach
(a) Net income approach (NIA): Under this approach, the cost of equity capital and cost of debt capital are assumed to be independent to the capital structure. The value of the firm rises by the use of more and more leverage and the weighted average cost of capital declines.
The crucial assumptions of this approach are:
- The use of debt does not change the risk perception of investors, as a result, the equity capitalisation rate and the debt capitalisation rate remain constant with changes in leverage.
- The debt capitalisation rate is less than the equity capitalisation rate
- Corporate income taxes do not exist
(b) Net operating income approach (NOIA): Under this approach, the cost of equity increases in accordance with leverage. Due to which the weighted average cost of capital remains constant and the value of the firm also remains constant as leverage is changed.
The critical assumptions of the NOIA approach are:
- The market capitalises the value of the firm as a whole. Thus the split between debt and equity is not important.
- The market uses an overall capitalisation rate to capitalise the net operating income. This rate depends on the business risk. If business risk is assumed to remain unchanged, the capitalisation rate is a constant.
- The use of the costly debt funds increases the risk of shareholders. This causes the equity capitalisation rate to increase. There the advantage of debt is offset exactly by the increase in equity capitalisation rate.
- The debt capitalisation rate is a constant
- Corporate income taxes do not exist.
Practical Problems
Problems on Cost of Capital:
Question 1.
AB Ltd. issues ₹ 1,00,000 9% debentures at a premium of 10%.
Solution:
Cost of Debt = Ki = \(\frac { I }{ Np }\) x (1 – T)
Np = 1,00,000 + 10% premium – Floatation cost
= 1,00,000 + 10,000 – 2,500 = 1,07,500
Ki = 9,000/1,07,500 (1 – 0.5) x 100 = 4.18 %
Question 2.
What is the net benefit cost ratio when benefit cost ratio is 1.40:1?
Solution:
Benefit cost ratio = 1.40:1
Total revenue = 1.40
Cost = 1
Therefore Net benefit = 1.40 – 1
= 40
Therefore Net benefit cost ratio = 0.4 : 1
Question 3.
The Market price of the equity of a Ltd. Co. is ₹ 160. The dividend expected after a year is ₹ 12 per Share. The dividend is expected to grow at a constant rate of 4 percent per annum. Find the rate of return required by shareholders.
Solution:
γe = \(\frac{\mathrm{D} 1 \mathrm{~V}_{1}}{\mathrm{P}_{0}}\)
Where γe = Rate of return required by shareholders
D1V1 = Expected dividend
P0 = Current market price
g = Growth rate of dividends.
∴ ye = \(\frac { 12 }{ 160 }\) + 0.04 = 0.075 + 0.04
ye = 0.115 or 11.5%
Hence the rate of return required by shareholders is 11.5%
Question 4.
The expected average earnings per share of a company are ₹ 16 and the current market price of the shares is ? 160. Find out the cost of equity.
Question 5.
The market price of a share is ₹ 255. A company anticipated earnings of ₹ 3,00,000 to be distributable among 30000 shareholders. The tax rate is 30 per cent. Find out the cost of internally generated retained earnings.
Question 6.
The shares of a leather Company are selling at 60 per shares. The firm has paid dividend at the rate of ₹ 3 per share. The growth rate is 9%. Compute cost of equity capital of the company.
Kc = \(\frac { D }{ P }\) + g
= \(\frac { 3 }{ 60 }\) + 0.09
= 0.05 + 0.09
= 0.14 x 100
= 14%
Question 7.
20 years 20% debentures of a firm are sold at a rate of ₹ 180. The face value of the debenture is 200, 50% tax is assumed. Find the cost of debt.
Question 8.
A Ltd, company with net operating earnings ₹ 6,00,000 you want to evaluate possible capital structures, shown below, Which capital structure you will select? Why?
Question 9.
XYZ Ltd. Co; has the following securities In its capital structure.
Source – Amount(₹)
Debt – 6,00,000
Preference capital – 4,00,000
Equity capital – 10,00,000
Total – 20,00,000
The after tax cost of capital is as follows
After tax cost
Cost of debt – 8%
Cost of preference shares – 14%
Cost of equity capital – 17%
From the above information compute weighted average cost of capital by using the book value weights.
Question 10.
Mr. Kiran is considering to purchase 20% ₹ 2,000 preference share redeemable after 6 years at par. What should he be willing to pay now to purchase the share assuming that the required rate of return is 14%.
Question 11.
A company issues a new 15% debentures of ₹ 1,000 face value to be redeemed after 10 years. The debentures are expected to be sold at 5% discount. It will also involve flotation cost of 5%. The company’s tax rate is 30%. What would be the cost of debt?
Question 12.
XYZ Company has debentures outstanding with 5 years left before maturity. The debentures are currently selling for ₹ 90 (face value is 100 ₹) The debentures are to be redeemed at 5% premium. The interest is paid annually at a rate of interest of 12%. The firm’s tax rate is 35%. Calculate Kd.
Question 13.
Alfa Ltd., with net operating earnings of ₹ 3 lakhs is attempting to evaluate a ,number of capital structures given below. Which of the capital structure will you recommend and why?
Question 14.
Kishan Limited wishes to raise additional finance of ₹ 20 Lakh for meeting its investment plans. It has ₹ 4,20,000 in the form of retained earnings available for Investment purposes. The following details are available.
1. Debt /equity mix 30% : 70%
2. Cost of debt upto ₹ 3,60,000 – 10% (Before tax)
Cost of debt beyond ₹ 3,60,000 – 16% (Before tax)
3. Earnings per share: 4
4. Dividend payout : 50% of earnings
5. Expected growth rate of dividend: 10%
6. Current market price: 44
7. Tax rate: 50%
You are required:
a. To determine the pattern for raising the additional finance.
b. To determine the post-tax average cost of additional cost.
c. To determine the cost of retained earnings and cost of equity.
d. Compute the overall weighted average after tax cost of additional finance.
Question 15.
Varsha Ltd. wishes to raise additional finance of ₹ 10 lakhs for meeting its investment plans. It has ₹ 2,10,000 in the form of retained earnings available for investment purposes. The following are the further details.
(a) Debt / Equity mix – 30% 70%
(b) Cost of debt
up to 1,80,000 – 10% (before tax)
beyond ₹ 1,80,000 – 16% (before tax)
(c) Earnings per share – ₹ 4
(d) Dividend payout – 50%
(e) Expected growth rate in dividend – 10%
(f) Current market price per share – ₹ 44
(g) Tax rate – 50%
You are required.
(a) To determine the pattern for raising additional finance.
(b) Compute the weighted average cost of capital.
Question 16.
Thee companies A,B, and C are in the same business and hence have similar operating risks. However, the capital structure of each firm is different.
Problems On Capital Structure
Question 1.
It is proposed to start a business requiring capital of ₹ 10 lakhs and expected return is 15%. Calculate EPS if
(a) Total capital required is financed by was of ₹ 100 equity.
(b) Is financed by way of 50% equity and 50% debt (10% Interest)
Note Tax rate 50%
Question 2.
The P Ltd, has equity share capital of ₹ 10,00,000 in shares of ₹ 10 each and debt capital of ₹ 10,00,000 at 20% interest rate. The output of the company is increased by 50% from 1,00,000 units to 1,50,000 units. Selling price per unit – ₹ 20, Variable cost per unit – ₹ 10, Fixed cost – ₹ 5,00,000, Tax rate – 40%.
You are required to calculate: (a) Percentage increase in EPS (b) Degree of operating leverage at 1,00,000 units and 1,50,000 units (c) Degree of financial leverage at 1,00,000 units and 1,50,000 units.
Question 3.
Determine the earnings per share of a company which has operating profit of ₹ 4,80,000. Its capital structure consists of the following securities.
Securities – Amount
10% debentures – 15,00,000
12% preference shares – 3,00,000
Equity shares of 100 ₹ each
The company is in the 55% tax bracket.
(1) Determine the company’s EPS (2) Determine the percentage change in EPS, associated with 30% increase and 30% decrease in EBIT. (3) Determine the degree of financial leverage.
Question 4.
A company needs ₹ 10,00,000 for construction of a new plant.
The following three financial plans are feasible.
(1) The company may issue 1,00,000 ordinary shares at ₹ 10 per share.
(2) The company may issue 50,000 ordinary shares at ₹ 10 per share and 5,000 debentures of ₹ 100 denomination bearing 8% rate of interest.
(3) The company may issue 50,000 ordinary shares at ₹ 10 per share and 5,000 preference shares at ₹ 100 per share bearing a 8% rate of dividend.
If the company’s earnings before interest and taxes are ₹ 20,000, ₹ 40,000, ₹ 80,000, ₹ 1,20,000 and ₹ 2,00,000 share. What are the earnings per share under each of the three financial plans? Which alternative would be recommended and why. Assume a corporate tax @ 50%.
Question 5.
The following information of a business concern is available who close their books of accounts on Dec 31st of every year. Calculate EPS and return on equity capital.
(a) 10,000 equity shares of 10 each and ₹ 8 paid up Rs 80,000
(b) 10% 12,000 preference shares of 10 each ₹ 1,20,000
(c) Profit before tax ₹ 80,000
(d) Rate of tax applicable 50%
Question 6.
The capital structure of ABC Ltd. consists of the following securities.
10% Debenture ₹ 5,00,000
12% Preference shares ₹ 1,00,000
Equity shares of ₹ 100 each ₹ 4,00,000
Operating profit (EBIT) of ₹ 1,60,000 and the company is in 50% tax bracket.
(1) Determine the company’s EPS.
(2) Determine the percentage change in EPS associated with 30% increse and 30% decrease in EBIT.
(3) Determine the financial leverage.
Question 7.
The Balance sheet of ABC company Ltd as on 31-12-2003 gives the following details.
Question 8.
A company has a capital of ₹ 2,00,000 divided into shares of ₹ 10 each It has major expansion programme requiring an investment of another ₹ 1,00,000. The management is considering the following alternatives for raising this amount.
(1) Issue of 10,000 shares of ₹ 10 each
(2) Issue of 10,000 12% preference shares of ₹ 10 each
(3) Issue of 10% debentures of ₹ 1,00,000
The, company’s present earnings before interest tax (EBIT) is ₹ 60,000 p.a. You are required to calculate the effect of each of the above modes of financing on the earnings per share (EPS) presuming:
(a) EBIT continues to be the same even after expansion
(b) EBIT increases by 20,000
(c) Assume tax liability as 50%
Question 9.
The Balance sheet of key Ltd on 31/12/2002
Balance Sheet
| Liabilities | Assets | ||
| Equity capital ₹ 10 per share 10% Debenture Retained earnings | 1,20,000 1,60,000 1,20,000 |
Net fixed assets Current Assets | 3,00,000 1,00,000 |
| 4,00,000 | 4,00,000 |
The company’s total turnover ratio is 3. Its fixed operating cost are ₹ 2,00,000 and the variable cost ratio is 40% The income tax rate is 50% a) Calculate for the company all the there types of leverages b) Determine the likely level of EBIT if EPS is ₹ 5.
Question 10.
The Balance Sheet of a company is as follows:
| Liabilities | Amount | Assets | Amount |
| Equity shares ₹ 10 each 10% Debenture P & L A/c Creditors | 6,00,000 8,00,000 2,20,000 4,00,000 |
Fixed assets Current Assets |
15,00,000 5,00,000 |
| 20,00,000 | 20,00,000 |
The company’s total assets turnover ratio is 5 times. Its fixed operating expenses are ₹ 10,00,000 and variable cost is 30%. Income Tax 50%.
1) Calculate all the leverages
2) Show the likely level of EBIT if EPS is a) 5 b) 3 c) 2
Question 11.
Compare two companies in terms of its financial, operating leverages and combined leverage.
Question 12.
The Capital Structure of the Progressive Corporation Ltd. Consist of an Equity Share capital of ₹ 10,00,000 (shares of ₹ 10 par value) and ₹ 10,00,000 of 20% Debentures. Sales increased by 25% from 2,0, 000 units to 2,50,000, the selling price is ₹ 10 per unit, variable cost amount to ₹ 6 per unit and fixed expenses amount to ₹ 2,50,000. Income tax rate is assumed to be 50%.
You are required to calculate the following:
i) The percentage increase in EPS
ii) The DFL at 2,00,000 units and 2,50,000 units.
iii) The DOL at 2,00,000 units and 2,50,000 units.
Question 13.
A company has EBIT of 4,80,000 and its capital structure consists of the following securities.
₹
Equity Share Capital (₹ 10 each) – 4,00,000
12% preference shares – 6,00,000
14.5% debentures – 10,00,000
The company is facing fluctuations in its sales. What would be the change in EPS.
(a) If EBIT of the company incresed by 25% and
(b) If EBIT of the company decreased by 25%. The corporate tax is 35%.
Question 14.
Omax Auto Ltd. has an equity share capital of ₹ 5,00,000 divided into shares of ₹ 1oo each. It wishes to raise further ₹ 3,00,000 for modernization. The company plans the following financing schemes:
(a) All equity shares
(b) ₹ 1,00,000 in equity shares and ₹ 2,00,000 in 10% debentures
(c) All in 10% debentures
(d) ₹ 1,00,000 in equity shares and ₹ 2,00,000 in 10% preference shares. The company’s EBIT is ₹ 2,00,000. The corporate tax is 50%. Calculate EPS in each case. Give a comment as to which capital structure is suitable.
Question 15.
A companys capital structure consists of the following:
Equity shares of ₹ 100 each ₹ 10,00,000
Retained earnings ₹ 5,00,000
9% Pref. shares ₹ 6,00,000
7% debentures ₹ 4,00,000
Total ₹ 25,00,000
The company earns 12% on its capital, the income tax rate is 50%. The company requires a sum of ?12,50,000 to finance its expansion programme for which the following alternatives are available.
(i) Issue of 10,000 equity shares at a premium of ₹ 25 per share.
(ii) Issue of 10% preference shares
(iii) Issue of 8% debentures.
It is estimated that the P/E ratios for equity, preference and debenture financing would be 21.4,17 and 15.7 respectively. Which of the three financing alternatives would you recommend and why?