Practical problems & solutions for MBA | MMS | M.Com | BBA | BMS | B.Com & Competitive exams
ABC Limited has equity with a market value of Rs. 20 Lacs and debt with a market value of Rs. 15 Lacs. The Balance sheet of the company showed the Capital Structure as under:
Capital Structure BV
Share Capital 10,00,000
Debentures 5,00,000
Bank Loan 8,00,000
Cost of debt is 9%. The risk-free rate is 8% and the market rate is 18%. The beta of the company is 0.15. The firm pays no taxes.
a) What is ABC Limited’s debt to equity ratio?
b) What is ABC Limited’s weighted average cost of capital based on Market value as
well as Book value? Answer up to 2 decimal places.
c) ABC Limited is in growing stage and soon the company will be under 35% tax bracket,
in such a scenario the company is thinking to raise the debt up to 70%. Under these
conditions, what will be the new DE ratio and the new cost of capital of the company?
d) What is the impact of change in DE ratio as above on the Company and why?
Given:
- Market value of equity (E): Rs. 20 lacs
- Market value of debt (D): Rs. 15 lacs
- Book value of share capital: Rs. 10,00,000
- Book value of debentures: Rs. 5,00,000
- Book value of bank loan: Rs. 8,00,000
- Cost of debt (rd): 9%
- Risk-free rate (Rf): 8%
- Market return (Rm): 18%
- Beta (β): 0.15
- Tax rate: Initially 0%, but soon 35%
- Target debt ratio: 70%
We will follow the steps to solve each question.
(d) Impact of Change in D/E Ratio:
- Lower WACC: With higher debt (70%), the WACC decreases to 6.95% from 9.29%, making the company more attractive for investments.
- Risk and Leverage: Increasing debt raises financial risk and could affect the company’s credit rating. However, the tax shield on interest payments reduces the cost of debt, improving profitability.
- Growth Opportunities: Lower WACC allows the company to pursue more growth opportunities, but the management must ensure it can handle the higher debt burden to avoid liquidity issues.
Summary of Answers:
(a) D/E Ratio (Market Value) = 0.75; D/E Ratio (Book Value) = 1.3
(b) WACC (Market Value) = 9.29%, WACC (Book Value) = 9.22%
(c) New D/E Ratio = 2.33, New WACC = 6.95%
(d) Increased debt lowers WACC but raises financial risk. Proper management of leverage can lead to growth and profitability.
XYZ Ltd. is evaluating a new project proposal with a cash outlay of Rs. 80,000. Cash inflows are 25,000 , 28,200 , 32,000, 12,000, 15,000. The project is being funded entirely by a bank loan raised at an interest rate of 9% p.a. Currently there is no tax applicability to the firm. Evaluate the project using NPV and IRR methodologies. The Board of Directors want a minimum of 12% as its rate of return on the project. Will the company take up the project?
How will the situation be different if the company is subject to a tax of 25%?
We will solve this step-by-step to determine if XYZ Ltd. should accept the project based on NPV (Net Present Value) and IRR (Internal Rate of Return).
Given:
- Initial Cash Outlay (Investment): Rs. 80,000
- Cash Inflows over 5 years: Rs. 25,000, 28,200, 32,000, 12,000, 15,000
- Interest Rate (Cost of Debt): 9% p.a.
- Required Rate of Return (Board’s target): 12%
- No tax initially, but the case changes with 25% tax later
Maya bought a house of value Rs. 65,00,000. She got a loan of 80% of the value of the house from the bank. The bank offered her a loan for 10 years @ 8.5% interest payable annually. Calculate the equated annual payment to be made by her and draw up her annual payment schedule.
Given:
- House Value (Principal): Rs. 65,00,000
- Loan Amount: 80% of Rs. 65,00,000 = Rs. 52,00,000
- Loan Tenure: 10 years
- Interest Rate (Annual): 8.5% p.a.
We need to calculate equated annual payments (EMI) and prepare the amortization schedule.
With the following data, calculate DSO and Debtor Turnover Ratio (in no. of times) for FY 2021-22. What is better for the company, a higher ratio or lower ratio? Give brief reasons? (In one line) (5 marks)
FY 2021-22 FY 2020-21
Sales 1,500,000 1,650,000
Receivables 30,000 35,000
60% of the sales are on credit basis
Corporate Finance Problems & Solutions
Corporate Value Additions & Economic Value Added
Note: The above posts only clarifies the process of solving the assignment and not the complete solution. The images has been taken from ICAI Books.
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