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CA Ipcc Assignment

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• CA-IPCC FM ASSIGNMENT

LEVERAGES, COST OF CAPITAL, CAPITAL STRUCTURE AND CASH FLOW STATEMENT

MM: 75 Marks

Question No. 1: ABC Ltd. has the following capital structure which is considered to be optimum as on 31st March 2006.

`

14% debentures 30,000

11% Preference shares 10,000

Equity (10,000 shares) 1,60,000

2,00,000

The company share has a market price of `23.60. Next year dividend per share is 50% of year 2006 EPS. The following is the

trend of EPS for the preceding 10 years which is expected to continue in future.

Year EPS (Rs.) Year EPS (Rs.)

1997 1.00 2002 1.61

1998 1.10 2003 1.77

1999 1.21 2004 1.95

2000 1.33 2005 2.15

2001 1.46 2006 2.36

The company issued new debentures carrying 16% rate of interest and the current market price of debenture is `96.

Preference share `9.20 (with annual dividend of `1.1 per share) were also issued. The company is 50% tax bracket.

(A) Calculate after tax:

(i) Cost of new debt

(ii) Cost of new preference shares

(iii) New equity funds (consuming new equity from retained earnings)

(B) Calculate marginal cost of capital when no new shares are issued.

(C) How much needs to be spent for capital investment before issuing new shares? 50% of the 2006 earnings are available as

retained earnings for the purpose of capital investment.

(D) What will the marginal cost of capital when the funds exceed the amount calculated in (C), assuming new equity is issued at

Rs. 20 per share?

(10 Marks) Answer 1:(A) (i) Cost of new debt

Kd = I (1 t)

NP

16 (1 - 0.50) = 8.33%

96

(ii) Cost of new preference shares

Kp = D = 1.1 = 11.96%

NP 9.2

(iii) Cost of new equity funds (Retained Earnings)

Kre = D1 + g = 1.18 + 0.10 = 15%

P0 23.60

D1 = 50% of 2006 EPS = 50% of 2.36 = ` 1.18

(B)

Type of Capital Optimum Weights Specific Cost WMCC

Debt 0.15 8.33% 1.25%

Preference 0.05 11.96% 0.60%

Equity 0.80 15.00% 12.00%

Marginal cost of capital 13.85%

(C) The company can spend the following amount of available Retained earnings (Breaking Point on exhaustion of RE) = (0.50)

(2.36 x 10,000) = ` 11,800

The ordinary equity is 80% of total capital.

Capital investment = `11,800 = `14,750

0.80

(D) If the company require fund in excess of `14,750 it will have to issue new shares. The cost of new issue will be

Ke = `1.18 + 0.10 = 15.90%

20

• The marginal cost of capital will be

Type of Capital Optimum Weights Specific Cost WMCC

Debt 0.15 8.33% 1.25%

Preference 0.05 11.96% 0.60%

Equity (New) 0.80 15.90% 12.72%

Marginal cost of capital 14.57%

Question No. 2: The XYZ & Co, wishes to find out its weighted marginal cost of capital, WMCC, based on target capital

structure proportions. Using the data given below, find out the Schedule of WMCC and also show the WMCC curve.

Source Proportion Range Cost

Equity Share Capital 50% Up to Rs.3,00,000 13.00%

3,00,000 7,50,000 13.30%

Above 7,50,000 15.50%

Preference Shares 10% Up to Rs.1,00,000 9,33%

Above 1,00,000 10.60%

Long Term Debt 40% Up to Rs.4,00,000 5.68%

4,00,000 8,00,000 6.50%

Above 8,00,000 7.10%

(8 Marks) Answer 2: Determination of breaking points of difference sources:

Source Weight Cost Range Breaking Points

Equity Capital 0.50 13.00% Up to `3,00,000 3,00,000/0.50 = 6,00,000

13.30% 3,00,000 7,50,000 7,50,000/0.50 = 15,00,000

15.50% Above 7,50,000 --

Preference Shares 0.10 9.33% Up to `1,00,000 1,00,000/0.10 = 10,00,000

10.60% Above 1,00,000 --

Long Term Debt 0.40 5.68% Up to `4,00,000 4,00,000/0.40 = 10,00,000

6.50% 4,00,000 8,00,000 8,00,000/0.40 = 20,00,000

7.10% Above 8,00,000 --

Now, the WMCC for different ranges of new financing may be calculated as follows:

Range (`) Source Weight COC% WACC%

Up to `6,00,000 Equity Share Capital 0.50 13.00 6.50

Preference Shares 0.10 9.33 0.93

Long Term Debt 0.40 5.68 2.27

WMCC 9.70

`6,00,000 10,00,000 Equity Share Capital 0.50 13.30 6.65

Preference Shares 0.10 9.33 0.93

Long Term Debt 0.40 5.68 2.27

WMCC 9.85

`10,00,000 15,00,000 Equity Share Capital 0.50 13.30 6.65

Preference Shares 0.10 10.60 1.06

Long Term Debt 0.40 6.50 2.60

WMCC 10.31

`15,00,000 20,00,000 Equity Share Capital 0.50 15.50 7.75

Preference Shares 0.10 10.60 1.06

Long Term Debt 0.40 6.50 2.60

WMCC 11.41

`20,00,000 and above Equity Share Capital 0.50 15.50 7.75

Preference Shares 0.10 10.60 1.06

Long Term Debt 0.40 7.10 2.84

WMCC 11.65

• 10.31%

The WMCC curve for the firm has been presented in the following Figure:

6 10 15 20 Total New financing (` Lacs)

Weighted Marginal Cost of Capital

Question No. 3: The following information is available for Rahul Limited.

Net operating income ` 60 lakh

Interest on debt ` 15 lakh

Cost of equity 17%

Cost of debt 13%

Calculate the average cost of capital for the firm. (4 Marks) Answer 3:

Total amount of Debt = ` 15 lakh

13%

= ` 115.38 lakh

Total amount of Equity = ` 60 lakh ` 15 lakh

17%

= ` 264.71 lakh

Total Debt & Equity = ` 115.38 lakh + ` 264.71 lakh = ` 380.09 lakh

Statement showing Computation of Average Cost of Capital

Source Amount

(` in lakhs)

Weight Cost WACC

Debt 115.38 0.304 13% 3.952%

Equity 264.71 0.696 17% 11.832%

380.09 1.00 15.784%

Therefore Average Cost of Capital for the firm = 15.78%.

Question No. 4: AK Ltd. provides you the following information

Income Statement

Particulars `

Sales (operating at 60% level of installed capacity) 6,00,000

Total costs (excluding interest but including fixed cost which is 1/6 of total cost) (5,40,000)

EBIT 60,000

Interest on Debentures @ 11% (44,000)

EBT 16,000

Income tax paid @ 40% (6,400)

Earnings after tax 9,600

Pref. Dividend paid @ 8% (4,000)

Earnings available for Equity Shareholders 5,600

Earnings per share of 100 each ` 11.20

MPS ` 112

Dividend paid per share ` 11.20

Cost of proposed expansion programme 50% of Total Assets at Present Flotation Cost associated with raising of finance `

5,000.

Sales expected to be increased by 33% from present level as a result of expansion.

11.41% 11.65%

9.85% 9.7%

9.0

9.5

10.0

10.5

11.0

11.5

12.0

12.5

WMCC%

• If AK Ltd. finances the expansion with debt, the rate of the incremental debt will be 1% more than that at present and the

price earnings ratio shall be 4 times. If expansion is financed through equity shares, the new share can be sold at 70% premium

and the price-earnings ratio shall be at present level. Required:

(a) Calculate the degree of all leverages at present and proposed sales level.

(b) Calculate EPS and percentage change in EPS if financing is through (i) Debt and (ii) Equity shares

(c) Calculate the market value per equity share under both the alternatives.

(d) Which form of financing should be employed?

(e) Determine the indifference point.

(f) Determine the financial break-even point, operating break-even point & Overall Break Even Point at present and proposed

sales levels.

(g) Determine that level of Indifference point between Debt Plan & Equity Plan & level of EBIT at which uncommitted earnings

per share (UEPS) would be same if sinking fund obligations amount to ` 50,000 per year.

(h) Shall the market price of share be same at the indifference point under all forms of financing?

(i) Which plan has more financial risk?

(j) Compute post tax cost of new debt & cost of new equity assuming that entire earnings will be distributed amongst equity

shareholders.

(20 Marks) Answer 4: Statement showing Calculation of Degree for various Leverages

Particulars Present

Situation (`)

Debt Plan

(`)

Equity

Plan (`)

Sales 6,00,000 8,00,000 8,00,000

Less: Variable Costs (75% of sales) (4,50,000) (6,00,000) (6,00,000)

Contribution 1,50,000 2,00,000 2,00,000

Less: Fixed Costs (1/6 x 5,40,000) (90,000) (90,000 (90,000)

Earnings before Interest & Tax 60,000 1,10,000 1,10,000

Less: Interest (44,000) (74,600) (44,000)

Earnings before Tax (EBT) 16,000 35,400 66,000

Less: Tax @ 40% (6400) (14,160 (26,400)

Earnings after Tax (EAT ) 9,600 21,240 39,600

Less: Pref. Dividend (4,000) (4,000) (4,000)

Earnings Available for Equity Shareholders (EAE) 5,600 17,240 35,600

No. of Equity Shares 500 500 2.000

(a) Operating Leverage (Contribution/EBIT) 2.50 1.82 1.82

Financial Leverage EBIT

EBT Pref. Dividend

1 t

6.429 3.828 1.854

Combined leverage (Operating Leverage x Financial Leverage) 16.07 6.97 3.37

(b) Earnings per share (EPS) [EAE/No. of Equity Shares] 11.20 34.48 17.80

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