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Inter_P6A_FM_Mod1_Chapter_4_Cost_of_Capital.pdf | FM | Study_Material | N/A | [Concept: Theory]
## COST OF CAPITAL
We find that the purchase price of Alpha Limited's share was ` 1,000 and the present value of the past five years of dividends plus the present value of the sale price at the discount rate of 12 per cent is ` 1,000.076. Therefore, the realised rate of return may be take... | [
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0.04016584903001785,
0.012780307792127132,
-0.02608000859618187,
-0.02197352424263954,
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0.010510309599339962,
-0.027117248624563217,
-0.011967196129262447,
0.0419125072658062,
0.04092767834663391,
0.02346348948776722,
0.007732590660452843,
0.0221... |
Inter_P6A_FM_Mod1_Chapter_4_Cost_of_Capital.pdf | FM | Study_Material | N/A | [Concept: Theory]
## ILLUSTRATION 11
CALCULATE the cost of equity from the following data using realized yield approach:
Year 1 2 3 4 5 Dividend per share( ` ) 1.00 1.00 1.20 1.25 1.15 Price per share (at the beginning) ( ` ) 9.00 9.75 11.50 11.00 10.60 | [
0.01138208992779255,
0.048349376767873764,
0.0014833691529929638,
-0.022191505879163742,
-0.008652211166918278,
-0.009996606968343258,
0.02260253205895424,
-0.009539674036204815,
0.007138018496334553,
0.04400694742798805,
0.005658043548464775,
0.026644838973879814,
0.0324595607817173,
-0.0... |
Inter_P6A_FM_Mod1_Chapter_4_Cost_of_Capital.pdf | FM | Study_Material | N/A | [Concept: Theory]
## FINANCIAL MANAGEMENT
The risk to which a security is exposed, can be classified into two groups:
- (i) Unsystematic Risk: This is also called company specific risk as the risk is related with the company's performance. This type of risk can be reduced or eliminated by diversification of... | [
0.010586694814264774,
0.051535144448280334,
0.014582829549908638,
-0.012314760126173496,
-0.015199889428913593,
-0.01817321963608265,
-0.0015829362673684955,
-0.019511118531227112,
-0.018523083999753,
0.07536430656909943,
0.04864960536360741,
0.010839700698852539,
0.027710899710655212,
0.0... |
Inter_P6A_FM_Mod1_Chapter_4_Cost_of_Capital.pdf | FM | Study_Material | N/A | [Concept: Theory]
## Risk Return relationship of various securities
Therefore, Required rate of return = Risk free rate + Risk premium
- ♦ The idea behind CAPM is that the investors need to be compensated in two ways- (i) Time value of money and (ii) Risk.
- ♦ The time value of money is represented by the risk-free r... | [
0.004093586932867765,
0.04548419639468193,
0.01737615279853344,
-0.008325654082000256,
-0.017192121595144272,
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0.014290554448962212,
-0.007863512262701988,
-0.015187430195510387,
0.06367053836584091,
0.042604513466358185,
0.020415032282471657,
-0.003094317391514778,
-... |
Inter_P6A_FM_Mod1_Chapter_4_Cost_of_Capital.pdf | FM | Study_Material | N/A | [Concept: Theory]
## The shortcomings of this approach are:
- (a) Estimation of beta with historical data is unrealistic; and
- (b) Market imperfections may lead investors to unsystematic risk.
Despite these shortcomings, the CAPM is useful in calculating cost of equity, even when the entity is suffering ... | [
0.01822556182742119,
0.046713937073946,
0.031230568885803223,
-0.012228435836732388,
-0.002569337375462055,
0.012471156194806099,
0.029269812628626823,
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0.04563338682055473,
0.05745437368750572,
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-0.020030060783028603,
-0.01... |
Inter_P6A_FM_Mod1_Chapter_4_Cost_of_Capital.pdf | FM | Study_Material | N/A | [Concept: Theory]
## 8. COST OF RETAINED EARNINGS (KR)
Like other sources of fund, retained earnings also involves cost. It is the opportunity cost of dividends foregone by shareholders.
The given below figure depicts how a company can either keep or reinvest cash or return it to the shareholders a... | [
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0.004853196907788515,
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-0.0035286610946059227,
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-0.04083732143044472,
0.03378390520811081,
-0.013806330040097237,
-0.027283325791358948,
0.04263879731297493,
0.01826881617307663,
0.02567431516945362,
0.024947399273514748,
-... |
Inter_P6A_FM_Mod1_Chapter_4_Cost_of_Capital.pdf | FM | Study_Material | N/A | [Concept: Theory]
## Cost of Retained Earnings
The cost of retained earnings is often used interchangeably with the cost of equity, as cost of retained earnings is nothing but the expected return of the shareholders from the investment in shares of the company. However, normally cost of equit... | [
-0.004993755370378494,
0.03542986512184143,
-0.007146991789340973,
-0.0034735912922769785,
0.0036942199803888798,
-0.054436009377241135,
0.048012569546699524,
-0.03189262002706528,
-0.023423582315444946,
0.04745972156524658,
0.024336397647857666,
0.03219049796462059,
0.019591273739933968,
... |
Inter_P6A_FM_Mod1_Chapter_4_Cost_of_Capital.pdf | FM | Study_Material | N/A | [Concept: Theory]
## ILLUSTRATION 13
Face value of equity shares of a company is ` 10, while current market price is ` 200 per share. Company is going to start a new project, and is planning to finance it partially by new issue and partially by retained earnings. You are | [
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0.04382609575986862,
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-0.053295545279979706,
0.05591509863734245,
-0.01249314472079277,
-0.008415285497903824,
0.046238817274570465,
0.03531845659017563,
0.016970131546258926,
0.04528927057981491,
0.00... |
Inter_P6A_FM_Mod1_Chapter_4_Cost_of_Capital.pdf | FM | Study_Material | N/A | [Concept: Theory]
## FINANCIAL MANAGEMENT
required to CALCULATE cost of equity shares as well as cost of retained earnings if issue price will be ` 190 per share and floatation cost will be ` 5 per share. Dividend at the end of first year is expected to be ` 10 and growth rate will be 5%. | [
0.008691317401826382,
0.033263590186834335,
-0.005106332711875439,
-0.0022340717259794474,
0.0013664993457496166,
-0.02497948706150055,
0.03570323437452316,
-0.011643278412520885,
-0.00012843357399106026,
0.0319901779294014,
0.024010874330997467,
0.02205679565668106,
0.004112717229872942,
... |
Inter_P6A_FM_Mod1_Chapter_4_Cost_of_Capital.pdf | FM | Study_Material | N/A | [Concept: Theory]
## 9. WEIGHTED AVERAGE COST OF CAPITAL (WACC)
To balance financial risk, ownership control over the company and cost of capital, a company usually does not procure entire fund from a single source, rather it makes a mix of various sources of finance. Hence, cost of total capi... | [
0.001119481516070664,
0.027129309251904488,
0.004953031428158283,
-0.011809928342700005,
0.03433387354016304,
-0.014721224084496498,
0.0066120256669819355,
-0.027019117027521133,
0.0010956770274788141,
0.05038869380950928,
0.0648302435874939,
-0.005290675442665815,
-0.02113487385213375,
-0... |
Inter_P6A_FM_Mod1_Chapter_4_Cost_of_Capital.pdf | FM | Study_Material | N/A | [Concept: Theory]
## The steps to calculate WACC is as follows:
Step 1: Calculate the total capital from all the sources of capital.
(Long-term debt capital + Pref. Share Capital + Equity Share Capital + Retained Earnings)
Step 2: Calculate the proportion (or %) of each source of capital to the total capit... | [
0.02512451633810997,
0.0410967580974102,
0.0017608902417123318,
0.00525584677234292,
0.030772540718317032,
-0.040688373148441315,
0.029268763959407806,
0.0033725150860846043,
0.0024360669776797295,
0.06401359289884567,
0.03927568718791008,
0.007411307189613581,
0.02610076032578945,
-0.0672... |
Inter_P6A_FM_Mod1_Chapter_4_Cost_of_Capital.pdf | FM | Study_Material | N/A | [Concept: Theory]
## Calculation of WACC
| Source of Capital | Cost of capital | % of total capital | Total |
|--------------------------|-------------------|----------------------|-------------------|
| Retained Earnings | 10% (K r ) | 25% (W r ) | 2.50% (K r ×W r ) |
| ... | [
0.014800917357206345,
0.04345833882689476,
0.0037712964694947004,
-0.0032952153123915195,
-0.0037522080820053816,
-0.009950260631740093,
0.0076705110259354115,
-0.010802722536027431,
-0.02510261721909046,
0.03169262409210205,
0.03428259864449501,
-0.0036204492207616568,
0.010250738821923733,... |
Inter_P6A_FM_Mod1_Chapter_4_Cost_of_Capital.pdf | FM | Study_Material | N/A | [Concept: Theory]
## 9.1 Choice of Weights
There is a choice of weights between the Book Value (BV) and Market Value(MV).
Book Value (BV): Book value weight is operationally easy and convenient. While using BV, reserves such as share premium and retained profits are included in the BV of equity, in addition to the no... | [
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0.0072225057519972324,
0.03366786614060402,
0.012851059436798096,
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-0.02051352709531784,
0.0411057285964489,
-0.03456496447324753,
-0.026993826031684875,
0.04721662402153015,
0.01996532641351223,
0.010144720785319805,
0.05868692696094513,
-0.0236... |
Inter_P6A_FM_Mod1_Chapter_4_Cost_of_Capital.pdf | FM | Study_Material | N/A | [Concept: Theory]
## FINANCIAL MANAGEMENT
| 3. Stability | Generally more stable, as it doesn't fluctuate with market conditions. | Can be volatile and fluctuate with market conditions. |
|----------------------------|------------------------------------------------... | [
0.03653644025325775,
0.026379311457276344,
0.00020639298600144684,
0.009710920043289661,
-0.03204483911395073,
-0.011174914427101612,
0.034510549157857895,
-0.006907029077410698,
0.0007479519117623568,
0.047786712646484375,
0.018829168751835823,
0.010863853618502617,
0.010855568572878838,
... |
Inter_P6A_FM_Mod1_Chapter_4_Cost_of_Capital.pdf | FM | Study_Material | N/A | [Concept: Theory]
## ILLUSTRATION 16
Cost of equity of a company is 10.41% while cost of retained earnings is 10%. There are 50,000 equity shares of ` 10 each and retained earnings of ` 15,00,000. Market price per equity share is ` 50. Calculate WACC using market value weights if there are no other sources of finance. | [
0.003073846222832799,
0.045651745051145554,
0.003990727476775646,
-0.008168666623532772,
0.01773453876376152,
-0.04291107505559921,
0.01716710813343525,
-0.016561640426516533,
-0.004460544791072607,
0.04381468519568443,
0.03634854778647423,
0.0271017886698246,
0.016340652480721474,
-0.0437... |
Inter_P6A_FM_Mod1_Chapter_4_Cost_of_Capital.pdf | FM | Study_Material | N/A | [Concept: Theory]
## SOLUTION
Book value of paid up equity capital = ` 5,00,000
Book value of retained earnings = ` 15,00,000
Ratio of Paid up equity capital & retained earnings = 5,00,000:15,00,000 = 1:3
Market value of paid up equity capital & retained earnings = ` 50,000 x ` 50
= ` 25,00,000
Market val... | [
0.026748334988951683,
0.053010351955890656,
0.00295339897274971,
0.014865873381495476,
-0.005496681667864323,
-0.06703734397888184,
0.036896150559186935,
-0.028538860380649567,
-0.00039354778709821403,
0.0574142262339592,
0.014238963834941387,
0.06223110854625702,
0.05162052810192108,
-0.0... |
Inter_P6A_FM_Mod1_Chapter_4_Cost_of_Capital.pdf | FM | Study_Material | N/A | [Concept: Theory]
## Calculation of WACC using market value weights
| Source of capital | Market Value | Weights | Cost of capital | WACC (K o ) |
|---------------------|----------------|-----------|-------------------|---------------|
| | ( ` ) | (a) | (b) | ... | [
0.037429749965667725,
0.0226504597812891,
0.0089006582275033,
0.0159374438226223,
-0.0010266572935506701,
-0.04596342518925667,
0.022753359749913216,
-0.014652184210717678,
-0.006995048373937607,
0.05131491273641586,
0.03724353387951851,
0.01796898804605007,
0.02949240617454052,
-0.0379987... |
Inter_P6A_FM_Mod1_Chapter_4_Cost_of_Capital.pdf | FM | Study_Material | N/A | [Concept: Theory]
## ILLUSTRATION 17
CALCULATE the WACC using the following data by using:
- (a) Book value weights
- (b) Market value weights
The capital structure of the company is as under:
| | ( ` ) |
|--------------------------------------|-----------|
| Debentures ( ` ... | [
0.030065307393670082,
0.023427607491612434,
0.03014184720814228,
-0.012842019088566303,
0.022292837500572205,
-0.0032896564807742834,
0.025437617674469948,
-0.0023447112180292606,
-0.011274020187556744,
0.03290317952632904,
0.03781123831868172,
0.021096516400575638,
0.03774421289563179,
-0... |
Inter_P6A_FM_Mod1_Chapter_4_Cost_of_Capital.pdf | FM | Study_Material | N/A | [Concept: Theory]
## (ii) Cost of Debt (Kd)
Current market price (P0) - floatation cost
<!-- formula-not-decoded -->
<!-- formula-not-decoded -->
Calculation of NPV at discount rate of 5% and 7%
| Year | Cash flows ( ` ) | Discount factor@ 5% | Present Value ( ` ) | Discount factor@ 7% | Present Value (... | [
0.017511902377009392,
0.03323952108621597,
-0.006524433847516775,
0.02358589507639408,
-0.031217828392982483,
-0.0536193922162056,
0.049849268049001694,
0.020256470888853073,
-0.013905045576393604,
0.042741816490888596,
0.034378182142972946,
0.00010453622962813824,
0.042904846370220184,
0.... |
Inter_P6A_FM_Mod1_Chapter_4_Cost_of_Capital.pdf | FM | Study_Material | N/A | [Concept: Theory]
## COST OF CAPITAL
| Year | Cash flows ( ` | Discount factor@ 3% | Present Value ( ` | Discount factor@ 5% | Present Value ( ` |
|---------|------------------|-----------------------|---------------------|-----------------------|---------------------|
| 0 | 107.8 | 1.000... | [
0.03777090832591057,
0.029158540070056915,
0.015331192873418331,
0.003960915841162205,
0.00005255802534520626,
-0.04179978370666504,
0.039581745862960815,
-0.0047668530605733395,
-0.007271799724549055,
0.06282834708690643,
0.04531830921769142,
0.005263884551823139,
0.028421316295862198,
-0... |
Inter_P6A_FM_Mod1_Chapter_4_Cost_of_Capital.pdf | FM | Study_Material | N/A | [Concept: Theory]
## (a) Calculation of WACC using book value weights
| Source of capital | Book Value | Weights | After tax cost of capital | WACC (K o ) |
|----------------------|--------------|-----------|-----------------------------|---------------|
| | ( ` ) | (a) | (... | [
0.03527574986219406,
0.02937372773885727,
0.01545931026339531,
0.004776762332767248,
0.006856800522655249,
-0.040723949670791626,
0.023543521761894226,
-0.009949573315680027,
-0.012706583365797997,
0.045730430632829666,
0.030819306150078773,
0.017361264675855637,
0.02714114636182785,
-0.03... |
Inter_P6A_FM_Mod1_Chapter_4_Cost_of_Capital.pdf | FM | Study_Material | N/A | [Concept: Theory]
## (b) Calculation of WACC using market value weights
| Source of capital | Market Value | Weights | After tax cost of capital | WACC (K o ) |
|--------------------------------|----------------|-----------|-----------------------------|---------------|
| ... | [
0.032567478716373444,
0.02543761022388935,
0.00046710853348486125,
0.017184384167194366,
-0.00806453451514244,
-0.04537152871489525,
0.027854520827531815,
0.001234212308190763,
-0.010191558860242367,
0.052706606686115265,
0.0391852930188179,
0.019085293635725975,
0.03774688020348549,
-0.03... |
Inter_P6A_FM_Mod1_Chapter_4_Cost_of_Capital.pdf | FM | Study_Material | N/A | [Concept: Theory]
## FINANCIAL MANAGEMENT
| 5% Preference shares ( ` 110× 5,000) | 5,50,000 | 0.158 | 0.0408 | 0.0064 |
|----------------------------------------|------------|---------|----------|----------|
| Equity shares ( ` 24× 1,00,000) | 24,00,000 | 0.691 | 0.10 | 0.0691 |
| Equity shar... | [
0.07662231475114822,
0.03023189678788185,
0.016050927340984344,
0.04556434229016304,
-0.030597107484936714,
-0.021682003512978554,
0.0388823077082634,
0.010947693139314651,
-0.021893706172704697,
0.0628281980752945,
0.04564085230231285,
0.027932798489928246,
0.020871160551905632,
0.0114487... |
Inter_P6A_FM_Mod1_Chapter_4_Cost_of_Capital.pdf | FM | Study_Material | N/A | [Concept: Theory]
## 10. MARGINAL COST OF CAPITAL
The marginal cost of capital may be defined as the cost of raising an additional rupee of capital. Since the capital is raised in substantial amount in practice, marginal cost is referred to as the cost incurred in raising new funds (over and above ... | [
-0.011437657289206982,
0.027615372091531754,
-0.016358068212866783,
-0.049123458564281464,
0.03308393806219101,
-0.015622084029018879,
0.03833885118365288,
-0.012630832381546497,
-0.035031359642744064,
0.03879177197813988,
0.058415576815605164,
0.011473911814391613,
-0.0022316379472613335,
... |
Inter_P6A_FM_Mod1_Chapter_4_Cost_of_Capital.pdf | FM | Study_Material | N/A | [Concept: Theory]
## ILLUSTRATION 18
ABC Ltd. has the following capital structure, which is considered to be optimum as on 31st March, 2023.
| | ( ` ) |
|-------------------------------|----------|
| 14% Debentures | 30,000 |
| 11% Preference shares | 10,000 ... | [
0.057316042482852936,
0.03927230089902878,
0.024205198511481285,
-0.0006102283368818462,
0.005728796124458313,
-0.01621917262673378,
0.027515392750501633,
0.007015396375209093,
-0.01666852831840515,
0.04828455671668053,
0.048071905970573425,
-0.0002682186895981431,
0.025718888267874718,
0.... |
Inter_P6A_FM_Mod1_Chapter_4_Cost_of_Capital.pdf | FM | Study_Material | N/A | [Concept: Theory]
## (A) CALCULATE after tax:
- (i) Cost of new debt
- (ii) Cost of new preference shares
- (iii) Cost of new equity share (assuming new equity from retained earnings)
- (B) CALCULATE marginal cost of capital when no new shares are issued. | [
0.0071860929019749165,
0.057375647127628326,
0.004343459382653236,
-0.028158320114016533,
-0.008304117247462273,
-0.061847228556871414,
0.021661534905433655,
-0.003327014157548547,
-0.010201850906014442,
0.046647027134895325,
0.03272288292646408,
0.03223437815904617,
0.02270115353167057,
-... |
Inter_P6A_FM_Mod1_Chapter_4_Cost_of_Capital.pdf | FM | Study_Material | N/A | [Concept: Theory]
## FINANCIAL MANAGEMENT
- (C) DETERMINE the amount that can be spent for capital investment before new ordinary shares must be sold. Assuming that the retained earnings for next year's investment is 50 percent of 2022.
- (D) COMPUTE marginal cost of capital when the fund exceeds t... | [
0.0108138807117939,
0.03234802186489105,
-0.011041129007935524,
-0.011729198507964611,
0.008690119720995426,
-0.012163814157247543,
0.027569329366087914,
-0.018894020467996597,
0.0014089266769587994,
0.05057868734002113,
0.04215480759739876,
0.00841185636818409,
0.012187748216092587,
-0.01... |
Inter_P6A_FM_Mod1_Chapter_4_Cost_of_Capital.pdf | FM | Study_Material | N/A | [Concept: Theory]
## SOLUTION
- (A) (i) Cost of new debt
<!-- formula-not-decoded -->
<!-- formula-not-decoded -->
- (ii) Cost of new preference shares
<!-- formula-not-decoded -->
- (iii) Cost of new equity shares
<!-- formula-not-decoded -->
<!-- formula-not-decoded -->
Calculation of g when there is a unifo... | [
0.038128167390823364,
0.04336630180478096,
0.019643660634756088,
0.01483146008104086,
-0.021695928648114204,
-0.03980329632759094,
0.024319728836417198,
0.010667025111615658,
-0.004798287525773048,
0.06828315556049347,
0.04265846312046051,
0.015226844698190689,
0.037876661866903305,
-0.012... |
Inter_P6A_FM_Mod1_Chapter_4_Cost_of_Capital.pdf | FM | Study_Material | N/A | [Concept: Theory]
## COST OF CAPITAL
| Preference Share | 0.05 | 0.1200 | 0.0060 |
|--------------------------|--------------------------|--------------------------|----------|
| Equity Share | 0.80 | 0.1500 | 0.1200 |
... | [
0.03471227362751961,
0.04983227699995041,
-0.0058058169670403,
0.0025386724155396223,
-0.005359235219657421,
-0.04113710671663284,
0.040566522628068924,
0.004073454532772303,
-0.01952754706144333,
0.06278591603040695,
0.05911553278565407,
0.022581377997994423,
0.0340038537979126,
-0.008549... |
Inter_P6A_FM_Mod1_Chapter_4_Cost_of_Capital.pdf | FM | Study_Material | N/A | [Concept: Theory]
## SUMMARY
- ♦ Cost of Capital: In simple terms, Cost of capital refers to the discount rate that is used in determining the present value of the estimated future cash proceeds of the business/new project and eventually deciding whether the business/new project is worth undertaking or not. It is als... | [
0.01134498044848442,
0.026556773111224174,
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-0.02617459185421467,
0.002431622939184308,
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0.04354670271277428,
-0.01627553068101406,
-0.02241532877087593,
0.038694433867931366,
0.045613814145326614,
-0.008857976645231247,
0.0030468557961285114,
-0... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## After studying this chapter, you would be able to -
- ♦ State the meaning and significance of Capital Structure.
- ♦ Discuss the various capital structure theories i.e., Net Income (NI) Approach, Traditional Approach, Net Operating Income (NOI) Approach, Modigliani and Miller (MM) Ap... | [
0.029720110818743706,
0.0019627802539616823,
0.023062771186232567,
-0.04477473348379135,
0.02661322057247162,
-0.027406755834817886,
0.006773910950869322,
0.0014948565512895584,
-0.014064299874007702,
0.05692944675683975,
0.006396321579813957,
0.03707822784781456,
0.03090646117925644,
-0.0... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## 1. MEANING OF CAPITAL STRUCTURE
Capital structure is the combination of capitals from different sources of finance. The capital of a company consists of equity share holders' fund, preference share capital and long term external debts. The source and quantum of capital is decided keepi... | [
0.02998581901192665,
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0.028641412034630775,
0.009688127785921097,
0.030166301876306534,
-0.013711904175579548,
0.023339705541729927,
-0.023240437731146812,
-0.06755657494068146,
0.03431854769587517,
0.06189269945025444,
0.0012682069791480899,
0.009919637814164162,
-0.... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## Where:
- ♦ Ko is the weighted average cost of capital (WACC)
- ♦ Kd is the cost of debt
- ♦ D is the market value of debt
- ♦ S is the market value of equity
- ♦ Ke is the cost of equity
Capital structure decision will decide weight of debt and equity and ultimately overall cost of cap... | [
0.02691245637834072,
0.012318365275859833,
0.014489265158772469,
0.020215284079313278,
-0.003709289012476802,
0.00608292780816555,
0.007630385924130678,
-0.0006244667456485331,
-0.055671971291303635,
0.05395308881998062,
0.0290702935308218,
-0.005890397820621729,
-0.011743674986064434,
-0.... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## 2. CAPITAL STRUCTURE THEORIES
The following approaches explain the relationship between cost of capital, capital structure and value of the firm:
<!-- image -->
- (a) Net Income (NI) approach
- (b) Traditional approach.
- (c) Net Operating Income (NOI) approach
- (d) Modigliani-Miller (MM) appr... | [
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0.05158383771777153,
0.02071039378643036,
0.029537327587604523,
0.024427540600299835,
-0.0320... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## 2.1 Net Income (NI) Approach
According to this approach, capital structure decision is relevant to the value of the firm. An increase in financial leverage will lead to decline in the weighted average cost of capital (WACC), while the value of the firm as well as market price of ordi... | [
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0.05690982565283775,
0.03761415556073189,
-0.0156580600887537,
0.02208689972758293,
-0.... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## ILLUSTRATION 1
Rupa Ltd.'s EBIT is ` 5,00,000. The company has 10%, ` 20 lakh debentures. The equity capitalization rate (Ke) is 16%.
You are required to CALCULATE:
- (i) Market value of equity and value of firm
- (ii) Overall cost of capital | [
-0.010162731632590294,
0.05116046592593193,
-0.004227098077535629,
-0.004515425302088261,
-0.0012018088018521667,
-0.040854312479496,
0.049457207322120667,
-0.01647089794278145,
-0.01251254789531231,
0.04004957899451256,
0.026623984798789024,
0.040322162210941315,
0.0358002595603466,
-0.03... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## (i) Statement showing Market value of equity and value of firm
| | ` |
|------------------------------------------------------------|------------|
| EBIT | 5,00,000 |
| Less:... | [
0.013027450069785118,
0.017113881185650826,
-0.004628526978194714,
0.014333507046103477,
-0.022628609091043472,
-0.04608345031738281,
0.05480283871293068,
-0.012051364406943321,
0.005001614801585674,
0.06229212507605553,
0.028154710307717323,
0.03599562123417854,
0.058982815593481064,
-0.0... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## 2.2 Traditional Approach
This approach favours that as a result of financial leverage up to some point, cost of capital comes down and value of firm increases. However, beyond that point, reverse trends emerges. The principle implication of this approach is that the cost of capital is dependen... | [
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0.026415808126330376,
0.013590510934591293,
-0.003827872918918729,
0.010737172327935696,
0.012273365631699562,
-0.014440306462347507,
-0.01840910315513611,
-0.046580493450164795,
0.05844724923372269,
0.04613165557384491,
0.00720487255603075,
-0.03114986978471279,
-0.0... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## Under this approach:
- i. The rate of interest on debt remains constant for a certain period and thereafter with an increase in leverage, it increases.
- ii. The expected rate by equity shareholders remains constant or increase gradually. After that, the equity shareholders... | [
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-0.026005031540989876,
0.0068576582707464695,
-0.011266065761446953,
0.05997394025325775,
0.035459909588098526,
-0.005886842031031847,
0.003535594791173935,
... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## Main Highlight of Traditional Approach
The firm should strive to reach the optimal capital structure and its total valuation through a judicious use of both the debt and equity in capital structure. At the optimal capital structure, the overall cost of capital will be minimum and the value of the ... | [
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0.024938490241765976,
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0.0069735911674797535,
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-0.006789799313992262,
-0.028682339936494827,
-0.021791527047753334,
0.05087790638208389,
0.04727138951420784,
0.012303425930440426,
-0.0012269295984879136,
... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## ILLUSTRATION 2
Indra Ltd. has an EBIT of ` 1,00,000. The company makes use of both the debt and equity capital. The firm has 10% debentures of ` 5,00,000 and the firm's equity capitalization rate is 15%.
You are required to COMPUTE:
- (i) Total value of the firm
- (ii) Overall cost of... | [
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0.039334192872047424,
-0.014603939838707447,
-0.03124067932367325,
0.02940407209098339,
-0.03836929798126221,
0.04633268713951111,
-0.015710005536675453,
-0.012410550378262997,
0.048176493495702744,
0.04708364978432655,
0.029710298404097557,
0.03284689784049988,
-0.... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## (i) Calculation of total value of the firm
| | ` |
|---------------------------------------|----------|
| EBIT | 1,00,000 |
| Less: Interest (@10% on ` 5,00,000) | 50,000 |
| Earnings available for equity holders | 5... | [
0.024777473881840706,
0.04256245493888855,
-0.009593840688467026,
0.0010123543906956911,
-0.011990359984338284,
-0.045384254306554794,
0.04945407807826996,
-0.009633151814341545,
-0.006271474529057741,
0.04179761931300163,
0.04975410923361778,
0.029436713084578514,
0.030772170051932335,
0.... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## ILLUSTRATION 3
DETERMINE the optimal capital structure of a company from the following information:
| Options | Cost of Debt (K d ) in % | Cost of Equity (K e ) in % | Percentage of Debt on total value (Debt +Equity) |
|-----------|----------------------------|------------------... | [
0.0395934097468853,
0.028790779411792755,
0.0203655157238245,
-0.007446883246302605,
-0.009130729362368584,
-0.0289782602339983,
0.004767807200551033,
0.005702697206288576,
-0.013367466628551483,
0.05413995310664177,
0.056472208350896835,
0.01074156817048788,
0.010270222090184689,
-0.00201... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## SOLUTION
Note that the ratio given in this question is not debt to equity ratio. Rather it is the debt to total value ratio. Therefore, if the ratio is 0.6, it means that capital employed comprises 60% debt and 40% equity.
<!-- formula-not-decoded -->
In this question total of... | [
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0.014231164939701557,
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0.00005692866398021579,
-0.007557356730103493,
-0.046448081731796265,
0.02776004932820797,
0.019593989476561546,
-0.0040374137461185455,
0.07292168587446213,
0.060431454330682755,
-0.0026906391140073538,
0.008244588039815426,
... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## 2.3 Net Operating Income (NOI) Approach
NOI means Earnings before interest and tax (EBIT). According to this approach, capital structure decisions of the firm are irrelevant.
Any change in the leverage will not lead to any change in the total value of the firm and the market price of shares, ... | [
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0.051245469599962234,
0.020376840606331825,
0.01681060902774334,
0.018918678164482117,
-0.... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## ILLUSTRATION 4
Amita Ltd.'s operating income (EBIT) is ` 5,00,000. The firm's cost of debt is 10% and currently the firm employs ` 15,00,000 of debt. The overall cost of capital of the firm is 15%.
You are required to CALCULATE:
- (i) Total value of the firm
- (ii) Cost of equity | [
-0.017858924344182014,
0.027535293251276016,
-0.03312181681394577,
0.012895607389509678,
0.011980907991528511,
-0.03392859548330307,
0.027325617149472237,
-0.03770771622657776,
0.005212150048464537,
0.021546227857470512,
0.04103919491171837,
0.0417330227792263,
0.02904190495610237,
-0.0159... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## (i) Statement showing total value of the firm
| | ` |
|---------------------------------------------------|------------|
| Net operating income (EBIT) | 5,00,000 |
| Less: Interest on debentures (10% of ` 15,00,000)... | [
0.01341528631746769,
0.019459690898656845,
0.005416211672127247,
-0.005375457461923361,
-0.009831107221543789,
-0.051592886447906494,
0.040957678109407425,
-0.011960103176534176,
-0.00033455845550633967,
0.05609177425503731,
0.03702535480260849,
0.027787985280156136,
0.03736055642366409,
0... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## (ii) Calculation of cost of equity
| | ` |
|----------------------------------------------------------------|-----------|
| Market value of debt (D) | 15,00,000 |
| Market value of equity (... | [
0.0034193568862974644,
0.022478841245174408,
-0.015490801073610783,
0.04883212968707085,
-0.01876569166779518,
-0.03302615135908127,
0.02577993832528591,
0.002869788557291031,
-0.007732588332146406,
0.05689068138599396,
0.04598361998796463,
0.024427078664302826,
0.04390161484479904,
-0.005... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## ILLUSTRATION 5
Alpha Ltd. and Beta Ltd. are identical except for capital structure. Alpha Ltd. has 50 per cent debt and 50 per cent equity, whereas Beta Ltd. has 20 per cent debt and 80 per cent equity (All percentages are in market-value terms). The borrowing rate for both the companies is 8 ... | [
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0.03275486081838608,
0.009274271316826344,
-0.013786992989480495,
-0.0277206189930439,
-0.0353391207754612,
0.005883343052119017,
0.00028643032419495285,
-0.04431194067001343,
0.05780482664704323,
0.02942841500043869,
0.03760252892971039,
0.017138412222266197,
-0.0113... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## (i) Return on Equity shares of Alpha Ltd.
| | ` |
|----------------------------------------------|-----------|
| Value of the company | 20,00,000 |
| Market value of debt (50% × ` 20,00,000) | 10,00,000 |
| Market val... | [
0.021841242909431458,
0.03598441556096077,
0.002892798278480768,
0.0038662159349769354,
-0.05214674770832062,
-0.041453514248132706,
0.008271790109574795,
-0.006070782896131277,
-0.032468512654304504,
0.05399768427014351,
0.029111729934811592,
0.05249200761318207,
0.022828400135040283,
0.0... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## (b) (i) Calculation of Implied rate of return on equity of Beta Ltd.
| | ` |
|--------------------------------------------|-----------|
| Total value of company | 20,00,000 |
| Market value of debt (20% × ` 20,00,000) | 4,00,... | [
0.012405802495777607,
0.0095922676846385,
-0.013853496871888638,
-0.002892842749133706,
-0.0414293073117733,
-0.03169172629714012,
0.03334054723381996,
0.004748080391436815,
-0.035324178636074066,
0.04193548858165741,
0.051884833723306656,
0.03980647772550583,
0.020253876224160194,
0.02391... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## FINANCIAL MANAGEMENT
<!-- formula-not-decoded -->
<!-- formula-not-decoded -->
- (ii) Implied required rate of return on equity of Beta Ltd. is lower than that of Alpha Ltd. because Beta Ltd. uses less debt in its capital structure. As the equity capitalisation is a linea... | [
0.021826786920428276,
0.0067865317687392235,
-0.010501972399652004,
-0.003690561046823859,
-0.03787176311016083,
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0.004322567954659462,
-0.006121456623077393,
-0.050940487533807755,
0.052447546273469925,
0.029112113639712334,
0.018354928120970726,
-0.009558047167956829,... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## 2.4 Modigliani-Miller (MM) Approach
The NOI approach is definitional or conceptual and lacks behavioural significance. It does not provide operational justification for irrelevance of capital structure. However, Modigliani-Miller (MM) approach provides behavioural justification for cons... | [
0.032037634402513504,
0.029651375487446785,
0.006522649899125099,
-0.034485407173633575,
-0.014207305386662483,
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-0.007534582633525133,
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0.0410468727350235,
0.02137681096792221,
0.024244040250778198,
-0.01681440882384777,
-... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## MM Approach - 1958: without tax:
This approach describes, in a perfect capital market where there is no transaction cost and no taxes, the value and cost of capital of a company remain unchanged irrespective of change in the capital structure. This approach is based on further following additional... | [
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0.05787842348217964,
0.013522817753255367,
0.008851169608533382,
0.014592723920941353,
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0.004690646193921566,
-0.002319732215255499,
-0.05569421499967575,
0.07720266282558441,
0.04434744641184807,
0.03384144604206085,
-0.01876707933843136,
-0.04... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## FINANCIAL MANAGEMENT
Based on the above assumptions, Modigliani-Miller approach derived the following three propositions:
- (i) Total market value of a firm is equal to its expected net operating income divided by the discount rate appropriate to its risk class decided by the market.
... | [
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0.030593713745474815,
0.0020517606753855944,
0.01208792719990015,
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0.0005783652886748314,
-0.018587136641144753,
-0.005700764711946249,
-0.03646881505846977,
0.05281743034720421,
0.030817510560154915,
0.007605737075209618,
-0.00542101077735424,
... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## MM Approach-1963: with tax
In 1963, MM model was amended by incorporating tax, they recognised that the value of the firm will increase, or cost of capital will decrease where corporate taxes exist. As a result, there will be some difference in the earnings of equity and debt-holders ... | [
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0.06802988797426224,
0.02350570634007454,
0.03279198333621025,
-0.029381338506937027,
-0... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## FINANCIAL MANAGEMENT
- (i) Value of a levered company = Value of an unlevered company + Tax benefit
<!-- formula-not-decoded -->
- (ii) Cost of equity in a levered company (Keg) = Keu + (Keu - Kd) Debt Debt +Equity
Where,
Keg
= Cost of equity in a levered company
Keu
= Cost of equity in an ... | [
0.02698877453804016,
0.013349942862987518,
0.0029725213535130024,
0.04164519160985947,
-0.04800344258546829,
-0.03383713588118553,
0.03987107425928116,
0.00951051339507103,
-0.04266819730401039,
0.06351322680711746,
0.018450284376740456,
0.04341302812099457,
0.027559788897633553,
-0.005173... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## (When value of levered firm is more than the value of unlevered firm)
There are two companies N Ltd. and M Ltd., having same earnings before interest and taxes (EBIT) of ` 20,000. M Ltd. is a levered company having a debt of ` 1,00,000 @ 7% rate of interest. The cost of equity of N Lt... | [
0.0035842254292219877,
0.027129795402288437,
-0.005448336713016033,
0.0027867660392075777,
0.006753849796950817,
-0.007140733301639557,
0.009278246201574802,
-0.012133719399571419,
-0.043700605630874634,
0.09928543120622635,
0.03380971774458885,
0.04102613404393196,
0.0010153540642932057,
... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## SOLUTION
| | Company | Company |
|------------|------------|-----------|
| | MLtd. | N Ltd. |
| EBIT (NOI) | ` 20,000 | ` 20,000 |
| Debt (D) | ` 1,00,000 | -- |
| K e | 11.50% | 10% |
| K d | 7% | -- |
<!-- for... | [
0.026931503787636757,
0.010940838605165482,
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0.04168403521180153,
-0.0006782803684473038,
-0.01203859131783247,
0.0637584775686264,
0.033479057252407074,
0.02990788407623768,
0.03816598281264305,
0.003... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## Alternate Strategy will be:
Sell your 10% shares of levered firm for ` 11,304.30 and borrow 10% of levered firm's debt i.e. ` 10,000 (10% of ` 1,00,000) and invest the money i.e. 10% in unlevered firm's stock:
Total resources /Money we have = ` 11,304.30 + ` 10,000 = ` 21,304.3 and you... | [
0.03846754878759384,
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0.02967585250735283,
0.029220743104815483,
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0.09034022688865662,
0.0387212373316288,
0.04585718363523483,
-0.0009776671649888158,
-0.00... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## FINANCIAL MANAGEMENT
Now your return remains the same i.e. ` 1,300 which you are getting from N Ltd. before investing in M Ltd. but still you have ` 1,304.3 excess money available with you. Hence, you are better off by doing arbitrage.
In the above example you have not invested entire amount rece... | [
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0.020207487046718597,
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0.09749453514814377,
0.04572504758834839,
0.027040870860219002,
-0.005352518986910582,
... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## ILLUSTRATION 7
Following data is available in respect of two companies having same business risk:
Capital employed = ` 2,00,000, EBIT = ` 30,000 and Ke = 12.5%
| Sources | Levered Company ( ` ) | Unlevered Company ( ` ) |
|-------------|-------------------------|-------------------------... | [
-0.002379319630563259,
0.040581706911325455,
-0.007259739097207785,
-0.008074413053691387,
0.0022923157084733248,
-0.03140266612172127,
0.0006282952963374555,
0.007191014010459185,
-0.017829574644565582,
0.07773538678884506,
0.03950853645801544,
0.01994471251964569,
0.005611618049442768,
-... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## 1. Valuation of firms
| Particulars | Levered Firm ( ` ) | Unlevered Firm ( ` ) |
|-------------------------------------------|----------------------|------------------------|
| EBIT | 30,000 | 30,000 ... | [
0.01514450740069151,
0.02286018617451191,
-0.006885342299938202,
-0.02927759476006031,
0.01032297033816576,
-0.010558679699897766,
0.02612529881298542,
0.014171349816024303,
-0.046914976090192795,
0.08347619324922562,
0.03110979124903679,
0.04068472981452942,
0.00435667997226119,
0.0063341... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## 2. Investment & Borrowings
| | ` |
|----------------------------------------------------|--------|
| Sell shares in Levered company ( ` 1,60,000 x 15%) | 24,000 |
| Borrow money ( ` 1,00,000 x 15%) | 15,000 |
| Buy share... | [
0.04945199191570282,
0.033606287091970444,
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0.025630276650190353,
0.009706028737127781,
-0.012712965719401836,
0.07763282209634781,
0.018775632604956627,
0.0473363995552063,
0.016274984925985336,
-0... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## (When value of unlevered firm is more than the value of levered firm.)
There are two companies U Ltd. and L Ltd., having same NOI of ` 20,000 except that L Ltd. is a levered company having a debt of ` 1,00,000 @ 7% and cost of equity of U Ltd. & L Ltd. are 10% and 18%... | [
0.008457249961793423,
0.03469618409872055,
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0.010313170030713081,
0.004196165595203638,
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0.011023709550499916,
0.000396833464037627,
-0.043867629021406174,
0.10977679491043091,
0.02729337103664875,
0.05013316497206688,
-0.008222835138440132,
-0.00... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## SOLUTION
| Particulars | Company | Company ... | [
0.031816255301237106,
0.02846773900091648,
0.00711385952308774,
0.0015905600739642978,
-0.028538528829813004,
-0.03676247224211693,
0.034818265587091446,
-0.009222008287906647,
-0.005234498530626297,
0.055441562086343765,
0.036157265305519104,
0.022666551172733307,
0.0433729887008667,
0.01... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## Arbitrage Process:
If you have 10% shares of unlevered firm i.e. investment of 10% of ` 2,00,000 = ` 20,000 and Return @ 10% on ` 20,000. Investment will be 10% of earnings available for equity i.e. 10% × ` 20,000 = ` 2,000. | [
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0.05002577230334282,
-0.030925599858164787,
-0.01743597723543644,
-0.007590664085000753,
-0.02804460935294628,
0.016479795798659325,
0.012457403354346752,
-0.030295340344309807,
0.09099144488573074,
0.03438068926334381,
0.0585658960044384,
-0.007835233584046364,
0.00... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## Alternative strategy will be:
Sell your shares in unlevered firm for ` 20,000 and buy 10% shares of levered firm's equity plus debt.
| 10% equity of levered firm | ` 7,222 |
|----------------------------------|-----------|
| 10% debt of levered firm | ` 10,000 |
| Tot... | [
0.03129361942410469,
0.03445511683821678,
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0.021870091557502747,
-0.03543217480182648,
-0.021948210895061493,
0.009985467419028282,
0.026894137263298035,
-0.018563350662589073,
0.08396030962467194,
0.03338528051972389,
0.05297074094414711,
0.004195680376142263,
0.0027... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## FINANCIAL MANAGEMENT
In both the cases the return received is ` 2,000 and still you have excess cash of ` 2,778.
Hence, you are better off by doing arbitrage i.e. you will start selling unlevered company shares and buy levered company's shares thereby pushing down the value of share... | [
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0.03309838846325874,
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-0.02274402603507042,
-0.010935848578810692,
0.0025407911743968725,
-0.026939263567328453,
0.10604148358106613,
0.0358448289334774,
0.0373770147562027,
-0.021974651142954826,
... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## ILLUSTRATION 9
Following data is available in respect of two companies having same business risk: Capital employed = ` 2,00,000, EBIT = ` 30,000
| Sources | Levered Company ( ` ) | Unlevered Company ( ` ) |
|-------------|-------------------------|---------------------------|
| Debt (@10%... | [
-0.003326316364109516,
0.03812764957547188,
-0.010522333905100822,
-0.01164435874670744,
0.01092726830393076,
-0.02960302121937275,
-0.0006984305800870061,
0.009415111504495144,
-0.008986519649624825,
0.08010009676218033,
0.037567272782325745,
0.019709881395101547,
0.0029518429655581713,
-... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## 1. Valuation of firms
| Particulars | Levered Firm ( ` ) | Unlevered Firm ( ` ) |
|-------------------------------------------|----------------------|------------------------|
| EBIT | 30,000 | 30,000 ... | [
0.03164127096533775,
0.023759866133332253,
-0.00707537867128849,
-0.008547200821340084,
-0.0198518019169569,
-0.028095124289393425,
0.022964855656027794,
0.0016444813227280974,
-0.020732957869768143,
0.06940297037363052,
0.03575487807393074,
0.037108637392520905,
0.022098900750279427,
0.00... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## FINANCIAL MANAGEMENT
| K e | 20% | 12.5% |
|-----------------------------------------------------------|----------|----------|
| Value of Equity (S) | 1,00,000 | 2,40,000 |
| (Earnings available to ... | [
0.039137646555900574,
0.020825257524847984,
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0.011900537647306919,
-0.025628382340073586,
-0.021967919543385506,
0.018062520772218704,
0.012365729548037052,
-0.021956466138362885,
0.07872626930475235,
0.022432513535022736,
0.02776547707617283,
0.015236714854836464,
-... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## ILLUSTRATION 10
Blue Ltd., an all equity financed company is considering the repurchase of ` 275 lakhs equity shares and to replace it with 15% debentures of the same amount. Current market value of the company is ` 1,750 lakhs with its cost of capital of 20%. The company's Earnings befo... | [
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0.03471507877111435,
0.008972879499197006,
-0.013883055187761784,
-0.023982113227248192,
-0.03365475311875343,
-0.011025032959878445,
-0.003996205050498247,
-0.012369305826723576,
0.05559533089399338,
0.0083797387778759,
0.021192964166402817,
0.03372068703174591,
-0.0... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## Workings:
Market Value of Equity
=
Net income (NI) for equity holders
K e
` 1,750 lakhs =
Net income (NI) for equity holders 0.20
Net Income to equity holders/EAT = ` 350 lakhs
Therefore, EBIT
$$= EAT (1-t) = 350 lakhs (1 - 0.3) ` = ` 500 lakhs$$ | [
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0.03341661021113396,
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0.056423742324113846,
0.009263535030186176,
-0.00920742005109787,
0.06772035360336304,
0.01807803474366665,
0.040110472589731216,
0.06253556907176971,
-0.... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## Income Statement
| | All Equity ( ` In lakhs) | Equity & Debt ( ` In lakhs) |
|------------------------------------|----------------------------|-------------------------------|
| EBIT (as calculated above) | 500 | ... | [
0.0037976473104208708,
0.0029200147837400436,
-0.025128476321697235,
0.008167196065187454,
-0.020673071965575218,
-0.03647404536604881,
0.03858441859483719,
0.006308669224381447,
0.00268481089733541,
0.06735582649707794,
0.01737895794212818,
0.04303392767906189,
0.03458539769053459,
-0.022... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## (ii) Overall Cost of Capital
Market Value of Equity = Market value of levered firm - Equity repurchased
$$= ` 1,832.50 lakhs - ` 275 lakhs = ` 1,557.50 lakhs$$
Cost of Equity (Ke)
=
$$Net Income to equity holders ×100 Market value of equity$$
$$= 321.12 lakhs ×100=20.62% 1,557.50 lakhs ` `$$... | [
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0.027342764660716057,
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0.03325740620493889,
-0.00947531033307314,
-0.025004182010889053,
0.07284673303365707,
0.026681236922740936,
0.02303151972591877,
0.02018638141453266,
-0.024... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## (iii) Cost of Equity
The impact is that cost of equity has risen by 0.62% (20.62% - 20%) due to the presence of financial risk i.e. introduction of debt in capital structure.
Note: Cost of Capital and Cost of equity can also be calculated with the help of following formulas, though there will be ... | [
-0.006627631839364767,
0.03188974782824516,
-0.01770121045410633,
0.009000283665955067,
0.013151561841368675,
-0.012804885394871235,
0.025075023993849754,
-0.006441666278988123,
-0.04999828338623047,
0.061438169330358505,
0.039808399975299835,
0.024452315643429756,
0.017395392060279846,
-0... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## 2.5 The Trade-off Theory
The trade-off theory of capital structure refers to the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits. Trade-off theory of capital structure basically entails offs... | [
0.006967205088585615,
0.004614679142832756,
0.05092466622591019,
0.015053906477987766,
-0.0030616195872426033,
-0.029522566124796867,
-0.013939487747848034,
0.0027134758420288563,
-0.04693549498915672,
0.04730012267827988,
0.04980190470814705,
-0.006439057178795338,
0.029239550232887268,
-... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## 2.6 Pecking Order Theory
This theory is based on Asymmetric information, which refers to a situation in which different parties have different information. In a firm, managers will have better information than investors. This theory states that firms prefer to issue... | [
-0.00010701997234718874,
-0.00632157176733017,
0.010767442174255848,
-0.01355578564107418,
0.0060320706106722355,
-0.02148786559700966,
0.010672435164451599,
0.028442099690437317,
-0.015151822939515114,
0.08146924525499344,
0.03084256313741207,
0.004127016756683588,
0.00024290094734169543,
... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## 3.1 Choice of source of funds
A firm has the choice to raise funds for financing its investment proposals from different sources in different proportions. It can:
- (a) Exclusively use debt (in case of existing company), or
- (b) Exclusively use equity capital, or
- (c) Exclusively use preferenc... | [
0.015589244663715363,
0.0270683653652668,
0.03440730646252632,
-0.0006269433069974184,
-0.003911983221769333,
-0.014059738256037235,
0.004842049442231655,
-0.01744539849460125,
-0.01832151599228382,
0.05436647683382034,
0.06787008047103882,
0.009116163477301598,
0.04199672490358353,
-0.026... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## 3.2 Factors affecting capital structure
<!-- image -->
While choosing a suitable financing pattern, certain fundamental principles should be kept in mind, to design capital structure, which are discussed below:
- (1) Financial leverage or Trading on Equity : The use of long-term... | [
0.019600888714194298,
0.03354308009147644,
0.03618699684739113,
0.020702790468931198,
0.0341058224439621,
0.014500385150313377,
0.01995878666639328,
-0.0169251449406147,
-0.04167306050658226,
0.08400213718414307,
0.04551345854997635,
0.0031238612718880177,
0.01540585421025753,
-0.031550433... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## FINANCIAL MANAGEMENT
- (5) Control Principle : While designing a capital structure, the finance manager may also keep in mind that existing management control and ownership remains undisturbed. Issue of new equity will dilute existing control pattern and it also involves higher cost... | [
0.03082704357802868,
0.0176449716091156,
0.03445398062467575,
0.013396126218140125,
-0.005241016391664743,
-0.018911154940724373,
0.030478553846478462,
-0.016331562772393227,
-0.0017996457172557712,
0.07832665741443634,
0.051273033022880554,
0.007341824937611818,
0.011980707757174969,
-0.0... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## 4. OPTIMAL CAPITAL STRUCTURE
Objective of financial management is to maximize wealth . Therefore, one should choose a capital structure which maximizes wealth. For this purpose, following analysis should be done:
- (1) EBIT-EPS-MPS analysis: Chose a capital structure whic... | [
0.01897544041275978,
0.04444299265742302,
0.018476687371730804,
0.019802095368504524,
0.0013408049708232284,
-0.025545794516801834,
-0.013060386292636395,
0.027768602594733238,
-0.027613241225481033,
0.04769986495375633,
0.06597048044204712,
0.016508905217051506,
0.013758407905697823,
-0.0... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## 5.1 Relationship between EBIT-EPS-MPS
The basic objective of financial management is to design an appropriate capital structure which can provide the highest wealth, i.e., highest MPS, which in turn depends on EPS.
Given a level of EBIT, EPS will be different under different ... | [
-0.013729231432080269,
0.05029894411563873,
0.02224547043442726,
0.021586066111922264,
-0.025711700320243835,
-0.007697495631873608,
-0.015146792866289616,
-0.0053037297911942005,
-0.048524435609579086,
0.02985745295882225,
0.027046285569667816,
0.017985163256525993,
0.04723259061574936,
-... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## ILLUSTRATION 11
Suppose that a firm has an all equity capital structure consisting of 1,00,000 ordinary shares of ` 10 per share. The firm wants to raise ` 2,50,000 to finance its investments and is considering three alternative methods of financing - (i) to issue 25,000 ordinary share... | [
0.03236517682671547,
0.03706078603863716,
0.003372292732819915,
-0.017957504838705063,
0.010338569059967995,
-0.02369880862534046,
0.010968786664307117,
-0.001737527665682137,
-0.01978997141122818,
0.07248688489198685,
0.038308702409267426,
0.03573254868388176,
0.023017747327685356,
-0.025... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## EPS under alternative financing plans:
| Particulars | Equity Financing ( ` ) | Debt Financing ( ` ) | Preference Financing ( ` ) |
|---------------------------------------------|--------------------------|------------------------|-----------------------------... | [
0.03370315581560135,
0.0333724282681942,
-0.004794445354491472,
0.02621830441057682,
-0.030485957860946655,
-0.025392133742570877,
-0.009855399839580059,
0.014019681140780449,
0.004947002045810223,
0.04172472655773163,
0.035059910267591476,
0.01654999703168869,
0.06857988983392715,
-0.0141... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## 5.2 Financial Break-Even Point (BEP) and Indifference Point Analysis
<!-- image -->
Financial break-even point is the minimum level of EBIT needed to satisfy all the fixed financial charges i.e. interests and preference dividends. It denotes the level of EBIT for which the company's EPS equ... | [
-0.01651538535952568,
0.05415304750204086,
0.014591275714337826,
0.03159024938941002,
-0.030635179951786995,
-0.06434659659862518,
0.007254335563629866,
0.02313188463449478,
-0.013284887187182903,
0.05214598402380943,
0.020297659561038017,
0.026095887646079063,
0.039793457835912704,
-0.032... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## ILLUSTRATION 12
Best of Luck Ltd., a profit making company, has a paid-up capital of ` 100 lakhs consisting of 10 lakhs ordinary shares of ` 10 each. Currently, it is earning an annual pre-tax profit of ` 60 lakhs. The company's shares are listed and are quoted in the range of... | [
0.030406249687075615,
0.040203627198934555,
-0.0024172209668904543,
-0.021364159882068634,
0.0003862558223772794,
-0.03774750232696533,
0.013312984257936478,
-0.004939177073538303,
-0.01577787846326828,
0.04412534460425377,
0.04945036768913269,
0.04597865045070648,
0.021210428327322006,
0.... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## Calculation of Earnings per share under the three options:
| | Options | Options | Options |
|---------------------... | [
0.029548488557338715,
0.0269208624958992,
0.0005232322728261352,
-0.015224822796881199,
-0.03512068837881088,
-0.030713066458702087,
0.014127644710242748,
0.015089742839336395,
0.0036033038049936295,
0.05766024440526962,
0.03020753711462021,
0.0447530671954155,
0.03301091492176056,
0.01127... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## FINANCIAL MANAGEMENT
| | ` | ` | ` |
|--------------------------------------------------------|-------------------------------------... | [
0.03762638568878174,
0.028811754658818245,
-0.013921757228672504,
-0.0026136073283851147,
-0.03792876377701759,
-0.022398315370082855,
0.034149374812841415,
0.005217761266976595,
-0.0007706329342909157,
0.042873892933130264,
0.02741614729166031,
0.03494873270392418,
0.0409957580268383,
0.0... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## ILLUSTRATION 13
Shahji Steel Limited requires ` 25,00,000 for a new plant. This plant is expected to yield earnings before interest and taxes of ` 5,00,000. While deciding about the financial plan, the company considers the objective of maximizing earnings per share. It has thr... | [
0.021847862750291824,
0.01960821822285652,
-0.0010583261027932167,
0.017051443457603455,
-0.03765382617712021,
-0.021418528631329536,
0.005984208080917597,
0.0045192064717411995,
-0.02577679231762886,
0.045758578926324844,
0.01445723045617342,
0.03373482823371887,
0.025905951857566833,
0.0... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## SOLUTION
Plan I =
Raising Debt of ` 2.5 lakh + Equity of ` 22.5 lakh
Plan II =
Raising Debt of ` 10 lakh + Equity of ` 15 lakh
Plan III =
Raising Debt of ` 15 lakh + Equity of ` 10 lakh | [
0.016943491995334625,
0.02070387452840805,
-0.019177857786417007,
0.0027170330286026,
-0.053250476717948914,
-0.04528743028640747,
0.026486992835998535,
0.009685314260423183,
0.006979990750551224,
0.07028425484895706,
0.023478785529732704,
0.026086371392011642,
0.0499546192586422,
-0.02233... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## Calculation of Earnings per share (EPS):
| | FINANCIAL PLANS | FINANCIAL PLANS | FINANCIAL PLANS |
|----------------------------|-------------------|-------------------|-------------------|
| Particulars | Plan I | Plan II | Plan... | [
0.019160130992531776,
0.03348309174180031,
-0.020151929929852486,
-0.026994703337550163,
-0.020544974133372307,
-0.048048604279756546,
0.017237281426787376,
0.023060603067278862,
-0.005731714423745871,
0.05735117569565773,
0.02194823883473873,
0.03950631618499756,
0.05259343981742859,
-0.0... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## (a) Calculation of interest on Debt
| Plan | | ` | ` |
|--------|---------------------|----------|----------|
| I | ( ` 2,50,000 × 10%) | | 25,000 |
| II | ( ` 2,50,000 × 10%) | 25,000 | |
| | ( ` 7,50,000 × 15%) | 1,12,500 ... | [
0.028481142595410347,
0.015865769237279892,
-0.01560580637305975,
0.0006775071960873902,
-0.040426600724458694,
-0.03286740183830261,
0.02302313596010208,
-0.0012368872994557023,
0.007213904056698084,
0.06488824635744095,
0.04846315085887909,
0.020763427019119263,
0.03855042904615402,
-0.0... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## ILLUSTRATION 14
The following data are presented in respect of Quality Automation Ltd.:
| | ( ` ) |
|-------------------------------------|-----------|
| Profit before interest and tax | 52,00,000 |
| Less: Interest on debentures @12% | 12,00,000 |
|... | [
0.029696455225348473,
0.0429568737745285,
0.01070689968764782,
0.01655280590057373,
-0.0385960228741169,
-0.023911699652671814,
0.021479802206158638,
-0.011190129444003105,
-0.011994179338216782,
0.06734592467546463,
0.027646338567137718,
0.023125961422920227,
0.02408689446747303,
0.010000... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## Option1: Loan option
<!-- formula-not-decoded -->
<!-- formula-not-decoded -->
<!-- formula-not-decoded -->
Debt equity ratio has crossed the limit of 35%, hence, PE ratio in this case will be 8 times and additional borrowing will be at the rate of 14%. | [
0.029745467007160187,
0.035052910447120667,
-0.007816582918167114,
0.03383659943938255,
-0.034372929483652115,
-0.021046726033091545,
0.04115975275635719,
0.005626587197184563,
0.017058687284588814,
0.0776657685637474,
0.0659681111574173,
0.013634058646857738,
0.019258622080087662,
0.00096... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## Option2: Equity option
Debt = ` 1,00,00,000
<!-- formula-not-decoded -->
<!-- formula-not-decoded -->
Debt equity ratio has not crossed the limit of 35% hence PE ratio in this case will remain at 10 times.
4. Number of equity shares to be issued in case of equity option @ ` 25 per share = ` ... | [
0.035712361335754395,
0.04151085019111633,
-0.004842628259211779,
0.0373418964445591,
-0.043763287365436554,
-0.019943464547395706,
0.030219892039895058,
0.010415192693471909,
0.000569087453186512,
0.0750143751502037,
0.0573122575879097,
0.00888742320239544,
0.020511185750365257,
0.0233756... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## Calculation of EPS and MPS under two financial options
| | Financial Options | Financial Options |
|----------------------------------------------... | [
0.031275033950805664,
0.02712286077439785,
-0.008006680756807327,
-0.0008516180678270757,
-0.031148139387369156,
-0.03542819991707802,
0.01378927007317543,
0.022749869152903557,
0.010578112676739693,
0.061611250042915344,
0.027344929054379463,
0.028419289737939835,
0.051963359117507935,
-0... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## 6.1 Over-Capitalisation
It is a situation where a firm has more capital than it needs or in other words assets are worth less than its issued share capital, and earnings are insufficient to pay dividend and interest. This situation mainly arises when the existing capital is not eff... | [
0.0053574033081531525,
-0.023134125396609306,
0.027032168582081795,
-0.008478214964270592,
0.045630719512701035,
-0.05732801929116249,
0.06137239560484886,
0.0044156638905406,
-0.0022137733176350594,
0.039114952087402344,
0.027080513536930084,
0.008827537298202515,
0.03451463207602501,
0.0... |
Inter_P6A_FM_Mod1_Chapter_5_Financing_Decisions_Capital_Structure.pdf | FM | Study_Material | N/A | [Concept: Theory]
## FINANCIAL MANAGEMENT
Remedies for Over-Capitalisation: Following steps may be adopted to avoid the negative consequences of over-capitalisation:
- (i) Company should go for thorough reorganization.
- (ii)
- Buyback of shares.
- (iii) Reduction in claims of debenture-holders and creditors.
- (iv) ... | [
0.010860896669328213,
-0.012751273810863495,
0.03015023283660412,
-0.003609165083616972,
0.02228230983018875,
-0.03806108981370926,
0.07233108580112457,
-0.011198742315173149,
-0.01299014501273632,
0.03404051437973976,
0.05116622522473335,
0.004045237321406603,
0.003363188821822405,
0.0303... |
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