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Questions and Answers
Which financing plan offers the lowest cost of capital?
What is the optimal debt-equity mix observed in the varying levels of debt-equity analysis?
If a company issues 50,000 12% preference shares at Rs. 10 each, what will be the effect on its EPS if EBIT is Rs. 4,00,000?
What is the after-tax cost of debt when the debt is 50% of total capital employed?
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Which combination of financial instruments would result in the highest EPS if EBIT increases by Rs. 1,00,000?
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What is the overall share capital of the company after the expansion program?
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Which financial plan corresponds to the highest after-tax cost of debt?
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For a company with 40,000 equity shares, what is the total equity capital?
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Study Notes
Cost of Capital Overview
- Weighted Average Cost of Capital (Ko) is calculated using a formula involving debt (KW) and equity (KW).
- Assess the lowest Ko to determine optimal financing conditions.
- The Debt-Equity Mix yielding the lowest Ko signifies the most efficient capital structure.
Capital Structure Planning
- To establish an optimal capital structure, evaluate various financing plans based on cost of capital:
- Plan A: Rs 8,00,000 debt, Rs 2,00,000 equity, after-tax cost of debt 14%, cost of equity 20%.
- Plan B: Rs 6,00,000 debt, Rs 4,00,000 equity, after-tax cost of debt 13%, cost of equity 18%.
- Plan C: Rs 5,00,000 debt, Rs 5,00,000 equity, after-tax cost of debt 12%, cost of equity 16%.
- Plan D: Rs 2,00,000 debt, Rs 8,00,000 equity, after-tax cost of debt 11%, cost of equity 18%.
- Plan C is identified as the optimal choice for minimizing cost of capital.
Varying Debt-Equity Mix Analysis
- Different debt levels affect overall cost of debt and cost of equity:
- 0% Debt: Cost of debt 7%, cost of equity 15%.
- 10% Debt: Cost of debt 7%, cost of equity 15%.
- 20% Debt: Cost of debt 7%, cost of equity 16%.
- 30% Debt: Cost of debt 8%, cost of equity 17%.
- 40% Debt: Cost of debt 9%, cost of equity 18%.
- 50% Debt: Cost of debt 10%, cost of equity 21%.
- 60% Debt: Cost of debt 11%, cost of equity 24%.
- Optimal debt-equity mix occurs at 10% debt and 90% equity or 20% debt and 80% equity, both yielding a composite cost of capital of 14.2%.
Financing Options for Expansion
- Share capital totals Rs. 10,00,000, needing an additional Rs. 5,00,000 for expansion.
- Evaluation of three financing alternatives:
- Issue 50,000 equity shares at par.
- Issue 50,000 preference shares at 12%.
- Issue debentures of Rs. 5,00,000 at 10%.
- Earnings Before Interest and Tax (EBIT) is Rs. 4,00,000 annually, analyzed under two scenarios:
- If EBIT remains the same: EPS results are 1.33 (equity), 1.40 (preference), 1.75 (debentures).
- If EBIT increases by Rs. 1,00,000: EPS results are 1.67 (equity), 1.90 (preference), 2.25 (debentures).
Current Capitalization Structure
- The company's current capital consists of:
- 4,000 debentures at 5%, totaling Rs 4,00,000.
- 2,000 redeemable preference shares at 8%, totaling Rs 2,00,000.
- 40,000 equity shares totaling Rs 4,00,000.
- Overall capital structure equals Rs 10,00,000.
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Description
This quiz delves into the concepts of capital structure and the process of calculating the Weighted Average Cost of Capital (Ko). Participants will apply their understanding to ascertain the optimal debt-equity mix for minimizing costs. Test your knowledge on financial concepts and planning!
