Taxmann's Financial & Strategic Management (FSM | FM & SM)

About the Author

Shri N.S. ZAD obtained his Commerce degree from Shivaji University of Kolhapur and cleared CS Final Exam in June 2005 held by Institute of Company Secretary of India (ICSI). He is in teaching line from last 20 years and has vast teaching experience for various professional courses like CA, CS & CMA at IPCC/Executive/Inter & Final Level. He has practical experience for working with medium and large size organizations and rm of Practicing Company Secretaries.

He has written following books which are published by Taxmann Publication:

Jurisprudence, Interpretation & General Laws (For CS Executive)

Economic, Business & Commercial Laws (For CS Executive)

MCQs on Corporate & Management Accounting (For CS Executive)

Securities Laws & Capital Market (For CS Executive)

Setting-up of Business Entities & Closure (For CS Executive)

Company Law (For CS Executive)

I-5

Preface to Sixth Edition

The Financial & Strategic Management is one of the most important subjects of the CS Executive Level. The legal aspects of nance are becoming increasingly important and a Company Secretary is expected to successfully and effectively handle, amongst other things, important aspects such as management of public issues, syndication of loans, obtaining project approvals, raising of nance through public deposits and debentures or bonds etc. This requires expert knowledge of diverse and complex procedures involved. Realizing that the services of a Company Secretary could be of immense use in this important area, the “Financial & Strategic Management” subject is introduced by the ICSI in its syllabus for CS Executive Level. Many CS Executive students nd this subject complicated and tricky as other subjects mainly focus on Acts, Rules & Regulations.

The book is designed exclusively as per the requirements of CS Examination pattern as prescribed by ICSI. Each chapter covers, Problems & Solutions along with Multiple Choice Questions. The book is a comprehensive work, with lucid and systematic presentation for theory, practical questions & MCQs.

I assure you all that CS Executive students studying for “Financial & Strategic Management” paper from this book will come out with ying colours.

I shall be grateful for any of your suggestion to improve the book further.

I-7

I am really thankful to my family members for their blessings and support in my career journey.

I am also thankful to TAXMANN and their staff for their cooperation in presenting the book to students all over India.

I thank you, one and all.

N.S. Zad

I-8 PREFACE TO SIXTH EDITION

Chapter-wise Marks Distribution

Note : J-June; D-December

S. No. Chapter 2019 2020 2021 2022 Average J D J D J D 1 Nature & Scope of Financial Management 9 8 6 3 6 6 6.33 2 Working Capital Management 4 3 3 4 4 6 4.00 3 Receivable Management 2 1 2 2 2 1 1.67 4 Inventory Management 6 2 2 2 3 1 2.67 5 Management of Cash & Marketable Securities 3 1 2 2 2.00 6 Leverages 5 2 7 9 6 4 5.50 7 Capital Structure 4 5 5 3 3 10 5.00 8 Cost of Capital 4 10 7 6 10 8 7.50 9 Capital Budgeting 6 4 12 8 6 4 6.67 10 Dividend Policy 4 7 7 6 4 4 5.33 11 Security Analysis & Portfolio Management 11 15 9 12 13 5 10.83 12 Project Finance & Types of Financing 2 2 2 6 3 9 4.00 13 Introduction to Management 1 8 6 8 5 5.60 14 Introduction to Strategic Management 4 6 6 3 7 7 5.50 15 Business Policy & Formulation of Functional Strategy 6 6 4 8 2 13 6.50 16 Strategic Analysis & Planning 23 8 12 8 13 4 11.33 17 Strategic Implementation & Control 3 5 6 8 5 5 5.33 18 Analyzing Strategic Edge 3 7 8 6 5 6 5.83 Total 100 100 100 100 100 100 100.00

I-9

PAGE About the Author I-5 Preface to Sixth Edition I-7 Chapter-wise Marks Distribution I-9 PART A : FINANCIAL MANAGEMENT Chapter 1 Nature and Scope of Financial Management 1.3 Chapter 2 Working Capital Management 2.1 Chapter 3 Receivables Management 3.1 Chapter 4 Inventory Management 4.1 Chapter 5 Management of Cash & Marketable Securities 5.1 Chapter 6 Leverages 6.1 Chapter 7 Capital Structure 7.1 Chapter 8 Cost of Capital 8.1 Chapter 9 Capital Budgeting 9.1 I-11 Contents

PAGE Chapter 10 Dividend Policy 10.1 Chapter 11 Security Analysis and Portfolio Management 11.1 Chapter 12 Project Finance and Types of Financing 12.1 PART B : STRATEGIC MANAGEMENT Chapter 13 Introduction to Management 13.3 Chapter 14 Introduction to Strategic Management 14.1 Chapter 15 Business Policy & Formulation of Functional Strategy 15.1 Chapter 16 Strategic Analysis & Planning 16.1 Chapter 17 Strategic Implementation & Control 17.1 Chapter 18 Analyzing Strategic Edge 18.1 I-12 CONTENTS

7 CHAPTER

Capital Structure

PROBLEM & SOLUTIONS

Problem No. 1] A company’s capital structure consists of the following:

The company earns 12% on its employed capital. The tax rate is 35%. The company requires a sum of ` 25 lakhs to finance its expansion programme for which following plans are available to it:

(

i) Issue 20,000 equity shares of ` 100 each at a premium of ` 25 per share, or

(

ii) Issue 10% preference shares, or

(

iii) Issue 8% debentures.

It is estimated that the price earning ratio in case of equity shares, preference shares and debentures financing would be 20, 17 & 16 respectively. You are required to:

(1) Evaluate each proposal and recommend the best plan.

(2) Calculate indifference points between Plan I & Plan II; Plan I & Plan III.

Ans.: Capital structure for new finance:

TAXMANN ®

7.1

` Equity Share of

100 each 40,00,000 Retained Earnings 10,00,000 9% Preference Shares 25,00,000 7% Debentures 25,00,000 1,00,00,000

Particulars Plan I Plan II Plan III Equity Shares 20,00,000 -Securities Premium 5,00,000 -10% Preference Shares - 25,00,0008% Debenture - - 25,00,000 25,00,000 25,00,000 25,00,000

7.2 CAPITAL STRUCTURE

Statement showing profit available for equity shareholder, EPS & Market Price:

TAXMANN ®

Particulars Present Plan I Plan II Plan III EBIT 12,00,000 15,00,000 15,00,000 15,00,000 (-) Interest - Existing (1,75,000) (1,75,000) (1,75,000) (1,75,000) - New - - (2,00,000) EBT 10,25,000 13,25,000 13,25,000 11,25,000 (-) Tax @ 35% (3,58,750) (4,63,750) (4,63,750) (3,93,750) PAT 6,66,250 8,61,250 8,61,250 7,31,250 (-) Preference dividend - Existing (2,25,000) (2,25,000) (2,25,000) (2,25,000) - New - - (2,50,000)Pro t available to equity shareholders 4,41,250 6,36,250 3,86,250 5,06,250 No. of equity shares 40,000 60,000 40,000 40,000 EPS 11.03 10.60 9.66 12.66 P/E Ratio - 20 17 16 Market Price (EPS × P/E Ratio) - 212 164.22 202.56 Calculation of indifferent point between Plan I & Plan II: (EBIT - I) (1 - t) - Dp = (EBIT - I) (1 - t) - Dp N N Let the EBIT be ‘x’. (x - 1,75,000) (1 - 0.35) - 2,25,000 = (x - 1,75,000) (1 - 0.35) - 4,75,000 60,000 40,000 0.65x - 1,13,750 - 2,25,000 = 0.65x - 1,13,750 - 4,75,000 6 4 0.65x - 3,38,750 = 0.65x - 5,88,750 6 4 2.6x - 13,55,000 = 3.9x - 35,32,500 - 1.3x = - 21,77,500 x = EBIT = 16,75,000 Calculation of indifferent point between Plan I & Plan III: (EBIT - I) (1 - t) - Dp = (EBIT - I) (1 - t) - Dp N N Let the EBIT be ‘x’.

2.6x - 13,55,000 = 3.9x - 28,12,500 - 1.3x = - 14,57,500

x = EBIT = 11,21,154

Problem No. 2] MC Ltd. is planning an expansion programme which will require ` 30 Crores and can be funded through one of the three following options:

(

a) Issue further equity shares of ` 100 each at par.

(

b) Issue loan at 15% interest.

(

c) Issue of preference shares at 12%.

Present paid up capital is ` 60 crores and average annual EBIT is ` 12 Crores. Assume income tax rate at 50%. After the expansion, EBIT is expected to be ` 15 Crores p.a.

Calculate EPS under the three financing options indicating the alternative giving the highest returns to the equity shareholder. Determine the point of indifference between equity shares capital and debt [i.e. options (a) & (b) above].

Ans.: Capital structure for new finance: (` in Crores)

CAPITAL STRUCTURE 7.3 TAXMANN ® (x - 1,75,000) (1 - 0.35) - 2,25,000 = (x - 3,75,000) (1 - 0.35) - 2,25,000 60,000 40,000 0.65x - 1,13,750 - 2,25,000 = 0.65x - 2,43,750 - 2,25,000 6 4 0.65x - 3,38,750 = 0.65x - 4,68,750 6 4

Particulars Option (a) Option (b) Option (c) Equity Shares 30 -15% Term Loan - 3012% Preference Shares - - 30 30 30 30 Statement showing profit available for equity shareholder and EPS: Particulars Option (a) Option (b) Option (c) EBIT 15 15 15 (-) Interest - (4.5)EBT 15 10.5 15 (-) Tax @ 50% (7.5) (5.25) (7.5) PAT 7.5 5.25 7.5 (-) Preference dividend - - (3.6) Pro t available to equity shareholder 7.5 5.25 3.9 No. of equity shares (in Crores) 0.9 0.6 0.6 EPS 8.33 8.75 6.50

CAPITAL STRUCTURE

Calculation of indifferent point between Option (a) & (b):

x = EBIT = 13.5

Problem No. 3] The Modern Chemicals Ltd. 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 objectives of maximizing earnings per share. It has three alternatives to finance the project - by raising debt of ` 2,50,000 or ` 10,00,000 or ` 15,00,000 and the balance, in each case, by issuing equity shares. The company’s shares is currently selling at ` 150, but it is expected to decline to ` 125 in case the funds are borrowed in excess of ` 10,00,000. The funds can be borrowed at the rate of 10% up to ` 2,50,000 and 15% up to ` 10,00,000 and at 20% over ` 10,00,000. The tax rate applicable to the company is 50%. Which form of financing should company choose?

Ans.: No. of equity shares to be issued under each Option:

TAXMANN ®

7.4

(EBIT - I) (1 - t) - Dp = (EBIT - I) (1 - t) - Dp N N Let the EBIT be ‘x’. (x - 0) (1 - 0.5) = (x - 4.5) (1 - 0.5) 0.9 0.6 0.5x = 0.5x - 2.25 0.9 0.6 0.3x = 0.45x - 2.025 - 0.15x = - 2.025

Crores

Option I = 22,50,000 = 15,000 shares 150 Option II = 15,00,000 = 10,000 shares 150 Option III = 10,00,000 = 8,000 shares 125 Capital structure for new finance: Particulars Option I Option II Option III Equity Share Capital 15,00,000 10,00,000 8,00,000 Securities Premium 7,50,000 5,00,000 2,00,000 Debt 2,50,000 10,00,000 15,00,000 25,00,000 25,00,000 25,00,000

Statement showing profit available for equity shareholder and EPS:

Analysis: Since EPS is maximum at Option II, it should be selected. Problem No. 4] A Company earns a profit of ` 3,00,000 per annum after meeting its interest liability of ` 1,20,000 on 12% Debentures. The tax rate is 50%. The number of equity shares of ` 10 each are 80,000 and the retained earnings amount to ` 12,00,000. The company proposes to take up an expansion scheme for which a sum of ` 4,00,000 is required. It is anticipated that after expansion, the company will be able to achieve the same return on investment as at present. The funds required for expansion can be either through debt at the rate of 12% or by issuing equity shares at par.

Required:

(

a) Compute the earning per share (EPS), if:

- The additional funds were raised as debt

- The additional funds were raised as equity shares.

(b) Advise the company as to which source of nance is preferable.

EBIT = 3,00,000 + 1,20,000 = 4,20,000

CAPITAL STRUCTURE 7.5 TAXMANN ®

Particulars Option I Option II Option III EBIT 5,00,000 5,00,000 5,00,000 (-) Interest - Up to ` 2,50,000 (25,000) (25,000) (25,000) - Next ` 7,50,000 - (1,12,500) (1,12,500) - Above ` 10,00,000 - - (1,00,000) EBT 4,75,000 3,62,500 2,62,500 (-) Tax @ 50% (2,37,500) (1,81,250) (1,31,250) PAT/Pro t available to equity shareholders 2,37,500 1,81,250 1,31,250 No. of equity shares 15,000 10,000 8,000 EPS 15.83 18.13 16.41

Ans.:

12% Debentures

1,20,000

10,00,000 0.12 Present Capital structure: Particulars ` Equity Share Capital 8,00,000 Retained Earnings 12,00,000 12% Debentures 10,00,000 30,00,000 Return on Capital Employed (ROCE) = EBIT × 100 = 4,20,000 × 100 = 14% Capital Employed 30,00,000

7.6 CAPITAL STRUCTURE

Capital structure for new finance:

EBIT after expansion = 34,00,000 × 14% = 4,76,000

Statement showing profit available for equity shareholder and EPS:

Analysis: EPS is high at Plan I, hence debt financing is preferred.

Problem No. 5] X Ltd. is considering the following two alternative financing plans:

The indifference point between the plans is ` 2,40,000. Corporate tax rate is 30%.

the rate of dividend on preference shares. Ans.: Calculation of indifferent point between Plan I & Plan II:

TAXMANN ®

Particulars Plan I Plan II Equity Share Capital - 4,00,000 12% Debt 4,00,0004,00,000 4,00,000

Particulars Present Plan I Plan II EBIT 4,20,000 4,76,000 4,76,000 (-) Interest - Existing (1,20,000) (1,20,000) (1,20,000) - New - (48,000)EBT 3,00,000 3,08,000 3,56,000 (-) Tax @ 50% (1,50,000) (1,54,000) (1,78,000) PAT/Pro t available to equity shareholder 1,50,000 1,54,000 1,78,000 No. of equity shares 80,000 80,000 1,20,000 EPS 1.875 1.925 1.48

Plan

I Plan

II Equity Shares of ` 10 each 4,00,000 4,00,000 12% Debentures 2,00,000Preference Shares of ` 100 each 2,00,000 6,00,000 6,00,000

Calculate

(EBIT

N1 N2 Let the dividend on preference shares

(2,40,000 - 24,000) (1 - 0.3) - 0 = (2,40,000 - 0) (1 - 0.3) - x 40,000 40,000 1,51,200 = 1,68,000 - x 4 4

- I) (1 - t) - Dp = (EBIT - I) (1 - t) - Dp

be ‘x’.

1,51,200 = 1,68,000 - x

- 16,800 = - x

x = Preference Dividend = 16,800

Rate

Preference

= 16,800 × 100 = 8.4% 2,00,000

Problem No. 6] NS Ltd. EBIT is 4,50,000. Which of the following capital structure will you recommend and why?

Analysis: Capital structure having debts of ` 4,50,000 is recommended as overall cost of capital is minimum.

Problem No. 7] Sun Ltd. and Moon Ltd. are identical in all respects including risk factors except for debt/equity mix. Sun Ltd. having issued 12% Debentures of ` 30 lakhs, while Moon Ltd. issued only equity capital. Both companies earn 24% before interest and taxes on their total assets of ` 50 lakhs. Assuming the corporate effective tax rate of 40% and capitalization rate of 18% for an all-equity company.

Compute the value of Sun Ltd. and Moon Ltd. using:

(

i) Net Income Approach

(

ii) Net Operating Income Approach

(iii) Using ‘Net Operating Income Approach’, calculate the overall ‘Cost of Capital’ for both the companies.

CAPITAL STRUCTURE 7.7 TAXMANN ®

Dividend

Capital structure Debt in capital structure Cost of debt (Kd) Cost of equity (Ke) 1 4,50,000 10% 12% 2 6,00,000 10% 12.5% 3 7,50,000 11% 13.5% 4 9,00,000 12% 15% Ignore taxation. Ans.: Determination of capital structure: Particulars 1 2 3 4 EBIT 4,50,000 4,50,000 4,50,000 4,50,000 (-) Interest (45,000) (60,000) (82,500) (1,08,000) EBT 4,05,000 3,90,000 3,67,500 3,42,000 Capitalization rate 12% 12.5% 13.5% 15% Market value of equity 33,75,000 31,20,000 27,22,222 22,80,000 Market value of debt 4,50,000 6,00,000 7,50,000 9,00,000 Total market value 38,25,000 37,20,000 34,72,222 31,80,000 Overall cost of capital (EBIT/Total market value) × 100 11.76% 12.10% 12.96% 14.15%

7.8 CAPITAL STRUCTURE

TAXMANN ®

Capital structure of Sun Ltd. & Moon Ltd.: Particulars Sun Ltd. Moon Ltd. Equity Share Capital 20,00,000 50,00,000 12% Debenture 30,00,000Total Assets 50,00,000 50,00,000 Calculation of total market value under Net Income Approach: Particulars Sun Ltd. Moon Ltd. EBIT 12,00,000 12,00,000 (-) Interest (3,60,000)EBT 8,40,000 12,00,000 (-) Tax @ 40% (3,36,000) (4,80,000) PAT/Net income available to equity shareholders (NI) 5,04,000 7,20,000 Capitalization rate 18% 18% Market value of equity (NI/Capitalization rate) × 100 28,00,000 40,00,000 Value of debt 30,00,000Total Market Value 58,00,000 40,00,000 Calculation of total market value under Net Operating Income Approach: Particulars Sun Ltd. Moon Ltd. Capitalization of earning = ( ) 12,00,000 10.4 18%     40,00,000 40,00,000 (-) Post tax value of debt 30,00,000 (1 - 0.4) (18,00,000)Value of equity 22,00,000 40,00,000 (+) Value of debt 30,00,000Total Market Value 52,00,000 40,00,000 Calculation of overall cost of capital under Net Operating Income Approach: Sun Ltd.: K e = D = 5,04,000 = 0.2291 i.e. 22.91% P0 22,00,000 Cost of debt: Kd = I (1 - t) = 12 (1 - 0.4) = 7.2%

Ans.:

Calculation of overall cost of capital (market value basis):

= 1,384.69 = 13.85% 100

Ltd.:

e = D = 7,20,000 = 0.18 i.e. 18% P0 40,00,000

Moon Ltd. has only one type of capital i.e. equity, hence cost of equity itself will be overall cost of capital.

Problem No. 8] Merry Ltd. has earnings before interest and taxes (EBIT) of ` 30,00,000 and 40% tax rate. It required rate of return on equity in the absence of borrowing is 18%. In the absence of personal taxes, what is the value of the company in an MM world (i) with ` 40,00,000 in debt and (ii) ` 70,00,000 in debt?

Ans.: Value of unlevered company:

According to MM, the value of levered firm would exceed that of the unlevered firm by an amount equal to the levered firms debt multiplied by the tax rate.

Value of unlevered firm + (Value of debt × Tax rate) = Total Value of levered firm

Value of the company with ` 40,00,000 in debt:

1,00,00,000 + (40,00,000 × 40%) = 1,16,00,000

Total value - Value of debt = Value of equity

1,16,00,000 - 40,00,000 = 76,00,000

Value of the company with ` 70,00,000 in debt:

1,00,00,000 + (70,00,000 × 40%) = 1,28,00,000

Total value - Value of debt = Value of equity

1,28,00,000 - 70,00,000 = 58,00,000

CAPITAL STRUCTURE 7.9 TAXMANN ®

Types of capital ` % Cost of Capital Product Equity Share Capital 22,00,000 42.31% 22.91% 969.32 12% Debentures 30,00,000 57.69% 7.2% 415.37 52,00,000 100% 1,384.69

WACC

Moon

Particulars ` EBIT 30,00,000 (-) InterestEBT 30,00,000 (-) Tax @ 40% (12,00,000) PAT 18,00,000 Capitalization rate 18% Market value of equity (PAT/Capitalization rate) × 100 1,00,00,000

7.10 CAPITAL STRUCTURE

Problem No. 9] Sky Ltd. and Universe Ltd. are identical in every respect except that Sky Ltd. use only equity in its capital structure while Universe Ltd. has debt of ` 6,00,000 at 15% interest. Corporate tax rate is 35%. EBIT is ` 2,00,000. Equity capitalization rate is 20%. Assuming that all assumption of MM are met determine value of Sky Ltd. and Universe Ltd. also determine weighted average cost of capital of the both the companies.

Ans.: Value of unlevered company: (Sky Ltd.)

According to MM, the value of levered firm would exceed that of the unlevered firm by an amount equal to the levered firms debt multiplied by the tax rate.

Value of unlevered firm + (Value of debt × Tax rate) = Total Value of levered firm

Value of the company with ` 6,00,000 in debt: 6,50,000 + (6,00,000 × 35%) = 8,60,000

Total value - Value of debt = Value of equity

8,60,000 - 6,00,000 = 2,60,000

Calculation of WACC of Sky Ltd.: Since there is no debt cost of equity itself will be WACC.

TAXMANN ®

Particulars ` EBIT 2,00,000 (-) InterestEBT 2,00,000 (-) Tax @ 35% (70,000) PAT 1,30,000 Capitalization rate 20%

Market value of equity (PAT/Capitalization rate) × 100 6,50,000

K e = 1,30,000 = 20% 6,50,000

of WACC

Universe Ltd.: Particulars ` EBIT 2,00,000 (-) Interest (90,000) EBT 1,10,000 (-) Tax @ 35% (38,500) PAT 71,500 K e = D = 71,500 = 0.275 i.e. 27.5% P0 2,60,000 Cost of debt: Kd = I (1 - t) = 15 (1

0.35) = 9.75%

Calculation

Calculation of overall cost of capital (market value basis):

Problem No. 10] RES Ltd. is an all equity financed company with a market value of ` 25,00,000 and cost of equity, Ke = 21%. The company wants to buyback equity shares worth ` 5,00,000 by issuing and raising 15% perpetual debt of the same amount. Rate of tax may be taken as 30%. After the capital restructuring and applying MM Model (with taxes), you are required to calculate:

(

i) Market value of RES Ltd.

(

ii) Cost of Equity Ke.

(

iii) Weighted average cost of capital and comment on it.

Ans.: Computation of EBIT of the unlevered company:

According to MM, the value of levered firm would exceed that of the unlevered firm by an amount equal to the levered firms debt multiplied by the tax rate. Value

unlevered firm + (Value of debt × Tax rate) = Total Value

CAPITAL STRUCTURE 7.11 TAXMANN ®

Types of capital ` % Cost of Capital Product Equity Share Capital 2,60,000 30.23% 27.5% 831.33 15% Debentures 6,00,000 69.77% 9.75% 680.26 8,60,000 100% 1,511.59 WACC =

1,511.59 = 15.12% 100

Particulars ` EBIT 7,50,000 (-) InterestEBT 7,50,000 (-) Tax @ 30% (2,25,000) PAT 5,25,000 Capitalization rate 21% Market value of equity (PAT/Capitalization

(given) 25,00,000 Perform reserve calculation to find out EBIT. Particulars All Equity Equity + Debt EBIT 7,50,000 7,50,000 (-) Interest - (75,000) EBT 7,50,000 6,75,000 (-) Tax @ 30% (2,25,000) (2,02,500) PAT 5,25,000 4,72,500

rate) × 100

Value of the company with

5,00,000 in debt: 25,00,000 + (5,00,000 × 30%) = 26,50,000

7.12 CAPITAL STRUCTURE

Total value - Value of debt = Value of equity

Calculation of overall cost of capital (market value basis):

Problem No. 11] Following is the data relating to Azad Ltd. and Bharat Ltd. belonging to the same risk class:

Explain how under MM approach, an investor holding 10% shares and debentures in Azad Ltd. will be better of in switching his holding to Bharat Ltd. [CS (Professional) - June 2005] (10 Marks)

for ` 14,30,000.

TAXMANN ®

K e = D = 4,72,500 = 0.2198 i.e. 21.98% P0 21,50,000 Cost of debt: Kd = I (1 - t) =

26,50,000 - 5,00,000 = 21,50,000

- 0.30) = 10.5%

Types of capital ` % Cost of Capital Product Equity Share Capital 21,50,000 81.13% 21.98% 1,783.24 15% Debt 5,00,000 18.87% 10.5% 198.14 26,50,000 100% 1,981.38 WACC

19.81%

= 1,981.38 =

100

Azad Ltd. Bharat Ltd. No. of equity shares 9,00,000 1,50,000 Market price per share (` ) 15 9 6% Debentures (` ) 8,00,000Pro t before interest (` ) 2,00,000 2,00,000 Dividend payout ratio 100% 100%

Ans.: Particulars Azad Ltd. Bharat Ltd. Pro t before interest 2,00,000 2,00,000 (-) Interest (48,000)Net Pro t 1,52,000 2,00,000 An investor

debentures

Azad Ltd.

and debentures

Debentures

owns 10% shares and

He sells his shares

= (9,00,000 × 15 × 10%) = 13,50,000

= (8,00,000 × 10%) = 80,000.

He wishes to purchase 10% equity shares in Bharat Ltd. which will cost him ` 1,35,000 (1,50,000 × 9 × 10%)

Thus, the income of investor remains the same and at the time he is left with ` 12,95,000 (14,30,000 - 1,35,000) of funds which can be invested elsewhere for generating additional income.

Problem No. 12] Two companies: P Ltd. & Q Ltd. belong to the equivalent risk group. The two companies are identical in every respect except that Q Ltd. is levered, while P Ltd. is unlevered. The outstanding amount of debt of the levered company is ` 6,00,000 in 10% debentures. The other information for the two companies is as follows:

An investor owns 5% equity shares in Q Ltd. show the process and the amount by which he could reduce his outlay through the use of arbitrage process. Is there any limit to the process?

[CS (Professional) - June 2006] (10 Marks)

Ans.: An investor owns 5% shares of Q Ltd. He sells his shares for ` 22,500 (4,50,000 × 5%). He wishes to purchase 5% equity shares in P Ltd. which will cost him ` 50,000 (10,00,000 × 5%)

He borrows an amount of ` 27,500 @ 10% p.a. and invests ` 50,000 i.e. 5% equity shares in P Ltd.

Thus, the income of the investor increases by switching form Q Ltd. to P Ltd. The above arbitrage process would continue till the price of the two companies comes to common equilibrium.

CAPITAL STRUCTURE

7.13 TAXMANN

Particulars Azad Ltd. Bharat Ltd. Dividend income (10% of net pro t) 15,200 20,000 Interest income (10% of interest on debentures) 4,800Net income 20,000 20,000

P Ltd. Q Ltd. Net operating income (EBIT) (` ) 1,50,000 1,50,000 Interest (` ) - 60,000 Earnings to equity-holders (` ) 1,50,000 90,000 Equity capitalization rate, Ke 0.15 0.20 Market value of equity (` ) 10,00,000 4,50,000 Market value of debt (` ) - 6,00,000 Total value of rm (` ) 10,00,000 10,50,000 Overall capitalization rate, Ko= EBIT/V 15.0% 14.3% Debt-equity ratio 0 1.33

Particulars P Ltd. Q Ltd. Dividend income (5% of pro t) 7,500 4,500 (-) Interest on amount borrowed (2,750)Net income 4,750 4,500

CAPITAL STRUCTURE

MCQs ON THEORY

1. _____ refers to the mix of a firm’s capitalization and includes long-term sources of funds.

(A) Leverage

(B) Capital structure

(D) Owner’s equity

2. The term “capital structure” refers to:

(A) Current assets & current liabilities

(B) Long-term debt, preferred stock, and common stock equity

(D) Shareholders’ equity

3. The decisions regarding the forms of financing, their requirements and their relative proportions in total capitalization are known as -

(A) Equity decisions

(B) Equilibrium decisions

(D) Capital structure decisions

4. Which of the following statement is false?

I. In case the rm wants to grow at a faster pace, it would be required to incorporate debt in its capital structure to a greater extent.

II. If the rm has no long-term debt in its capital structure, it means that either it is risk averse or it has cost of equity capital or cost of retained earnings less than the cost of debt. Select the correct answer from the options given below:

(A) Statement I is true while Statement II is false.

(B) Statement I is false while Statement II is true.

(D) Both Statement I and Statement II are true.

5. While designing a capital structure a finance manager should choose a pattern of capital which -

(A) Minimizes cost of capital

(B) Maximizes the owners return.

(D) Both (A) and (B)

6. Which of the following changes in capital structure would you recommend for growth at faster rate?

(A) Incorporate more retained earnings out of pro t and loss account.

(B) Incorporate debt in its capital structure to a greater extent.

(D) Pay more dividend to equity shareholders.

7. The manner in which an organization’s assets are financed is referred to as its -

(A) Capital structure

(B) Financial structure

(D) Owners structure

8. Optimal capital structure consists of -

(A) Appropriate mix of xed assets and current assets.

(B) Appropriate mix of long-term debts and xed assets.

(D) Appropriate mix of debt and equity.

9. Which of the following is not included in capital structure?

(A) Long-term debt

(B) Preferred stock

(D) Retained earnings

7.14

TAXMANN ®

10. Which of the following shows significance of capital structure?

(A) Capital structure re ects the overall strategy of the rm.

(B) One can get a reasonably accurate broad idea about the risk pro le of the rm from its capital structure.

(D) All of the above

11. Financial structure involves creation of -

(1) Long-term assets

(2) Short-term assets

Select the correct answer from the options given below:

(A) (2) only

(B) Neither (1) nor (2)

(D) Both (1) and (2)

12. Which of the following statement is incorrect?

1. High debt funds in capital structure increases EPS.

2. High debt funds increases the operating or business risk.

Select the correct answer from the options given below:

(A) Both Statement 1 and Statement 2 are correct.

(B) Statement 1 is correct while Statement 2 is incorrect.

(D) Both Statement 1 and Statement 2 are incorrect.

13. Financial structure is ______ concept while capital structure is _____ concept

(A) inappropriate; appropriate

(B) appropriate; inappropriate

(D) broader; narrow

14. Assertion (A):

The capital structure should be determined within the debt capacity of the company and this capacity should not be exceeded.

Reason (R):

The debt capacity of a company depends on its ability to generate future cash flows. It should have enough cash to pay creditors’ fixed charges and principal sum. Select the correct answer from the options given below:

(A) A is true but R is false

(B) A is false but R is true.

(D) Both A and R are true and R is correct explanation of A.

15. Which of the following capital structure consist of zero debt components in the structure mix?

(A) Pyramid Shaped Capital Structure

(B) Inverted Pyramid Shaped Capital Structure

(D) Vertical Capital Structure

16. Which of the following statement is false?

(A) The use of excessive debt threatens the solvency of the company.

(B) A rm having operating loss would nd it worthwhile to incorporate debt in the capital structure in a greater measure.

(D) None of the above

17. One can get a reasonably accurate broad idea about the risk profile of the firm from its -

(A) Dividend policy

(B) Capital structure

(D) Earning yield

CAPITAL STRUCTURE 7.15 TAXMANN ®

CAPITAL STRUCTURE

18. A critical assumption of the net operating income (NOI) approach to valuation is that:

(A) Debt and equity levels remain unchanged.

(B) Dividends increase at a constant rate.

(D) Interest expense and taxes are included in the calculation.

19. If the debt component in the capital structure is predominant -

(A) The xed interest cost of the rm will be minimum thereby decreasing its risk.

(B) Earnings per share (EPS) will be very low.

(D) The xed interest cost of the rm increases thereby increasing its risk.

20. Capital structure relates to _____ capital deployment for creation of ______ assets.

(A) long-term; long-term

(B) long-term; short-term

(D) short-term; short-term

21. Assertion (A):

The capital structure acts as a tax management tool also.

Reason (R):

Relatively lesser component of equity capital is vulnerable to hostile takeovers. Select the correct answer from the options given below:

(A) A is true but R is false

(B) A is false but R is true.

(D) Both A and R are true and R is correct explanation of A.

22. Select which of the following statement is correct.

Horizontal capital structure -

1. is quite stable.

2. is formed by a small amount of equity share capital.

3. there is absence of debt.

4. have increasing component of debt. Select the correct answer from the options given below:

(A) 1, 2 & 4

(B) 2 & 3

(D) 1 & 4 only

23. One can design capital structure with proper proportions of equity, preference and debt mix. The choice of the combination of these sources is called -

(A) Structural mix

(B) Policy mix

(D) Finance mix

24. In horizontal capital structure -

(A) Expansion of the rm takes place by issuance of debt securities.

(B) Expansion of the rm takes place by issuance of debt securities and preferred stocks.

(D) Expansion of the rm takes place by issuance of short-term and marketable securities.

25. According to Cost Principle an ideal pattern or capital structure is one that -

(A) Minimizes cost of capital structure

(B) Maximizes earnings per share (EPS).

(D) None of the above

7.16

TAXMANN

26. In a ________, the base of the structure is formed by a small amount of equity share capital. This base serves as the foundation on which the super structure of preference share capital and debt is built.

(A) Horizontal capital structure

(B) Vertical capital structure

(D) Matrix capital structure

27. According to Risk Principle -

(A) Reliance is placed on excessive use of debt nancing for capital requirements than common equity.

(B) Reliance is placed on ability of nance manager than external analyst.

(D) Reliance is placed more on short term nance for nancing capital requirements than excessive use of working capital.

28. Match List I with List II: List I List II

29. U se of more and more debt and preference capital -

(A) Affects equity share values and in unfavourable situation equity share prices may consequently drop.

(B) Increases value of debt and preference capital and equity share.

(D) All of the above

30. Match List I with List II: List I List II

P. Horizontal Capital Structure

Q. Credit Management

R. Vertical Capital Structure

S. Capital budgeting decision

1. High EPS

2. IRR

3. ARR

4. Incremental investment in debtors

5. Low EPS Select

CAPITAL STRUCTURE 7.17 TAXMANN ®

Capital Structure 1. Core Current Assets B. Dividend Policy 2. Financial Leverage C. Tandon Committee 3. Current Assets D. Stock 4. Fixed Assets 5. Annual Dividend Select the correct answer from the options given below: A B C D (A) 5 2 3 1 (B) 2 5 3 1 (C) 3 4 1 2 (D) 2 5 1 3

the correct answer

given below: P Q R S (A) 1 4 5 2 (B) 4 5 1 2 (C) 5 4 1 2 (D) 5 4 2 1

Business Risk is -

Avoidable risk

Unavoidable risk

Not relevant

Less important than nancial risk

from the options

31.

(A)

(B)

(C)

(D)

capital structure?

32. Which of the following statement is true in relation to vertical

(A) The incremental addition in the capital structure is almost entirely in the form of debt.

(B) The absence of debt it results in the lack of nancial leverage and hence low nancial risk.

(D) For this capital structure combined leverage is very low as compared to other rms in industry which have more equity nance.

33. The rate of tax affects the -

(A) Cost of retained earning

(B) Cost of debt

(D) All of the above

34. A pyramid shaped capital structure has -

(A) Retained earnings of the rm which are usually lower than the cost of debt.

CAPITAL STRUCTURE TAXMANN

(B) A large proportion consisting of equity capital and retained earnings which have been ploughed back into the rm over a considerably large period of time.

(D) Both (A) and (B)

35. Assertion A:

While making a choice of the capital structure the future cash flow position should be kept in mind.

Reason R:

Debt capital should be used only if the cash flow position is really good because a lot of cash is needed in order to make payment of interest and refund of capital.

Select the correct answer from the options given below:

(A) A is true and R is false

(B) A is false and R is true

(D) Both A and R are true and R is correct explanation of A.

36. To have optimal capital structure the firm must fulfil the following conditions:

I. Return on investment should be greater than cost of investment.

II. There should be minimum nancial risk.

III. There is absence of equity nance.

IV. The capital structure should be exible

V. Cost of investment should be greater than ROI.

Select correct answer from the options given below:

(A) III, V & I

(B) IV, II & V

(D) II & IV

37. Business risk is influenced by -

(A) Revenue

(B) Variable cost

(D) All of the above

38. Capital Structure of a firm -

(A) Is a re ection of the overall investment and nancing strategy of the rm.

(B) Shows how much reliance is being placed by the rm on external sources of nance and how much internal accrual is being used to nance expansions

(D) All of the above

39. With the help of Interest Coverage Ratio

(ICR) ratio an effort is made to find out -

7.18

(A) How many times the pro t after tax (PAT) is available to the payment of interest.

(B) How many times the net operating pro t after tax (NOPAT) is available to the payment of interest.

(D) Most suitable bank for negotiation.

40. Pyramid Shaped Capital Structure -

(A) Have a high proportion of xed assets and considerably a very low proportion of current assets.

(B) Have a high proportion of debts and considerably a very low proportion of equity.

(D) Have a high proportion of current assets and considerably a very low proportion of liquid assets.

41. Financial Risk is -

(A) Affected by demand of rm products, variations in prices and proportion of xed cost in total cost.

(B) Represented by the variability of earnings before interest and tax (EBIT)

(D) All of the above

42. Inverted Pyramid Shaped Capital Structure -

(A) Has a large component of equity capital.

(B) Is highly stable and permanent.

(D) Has reasonable level of debt but an ever increasing component of retained earnings.

43. Which of the following statement is true?

(

i) Flexibility principle states that the management chooses such a combi-

nation of sources of nancing which it nds easier to adjust according to changes in need of funds in future too.

(ii) Penalty for not meeting nancial obligations is bankruptcy.

(iii) Firms with high business risk therefore tend toward less highly leveraged capital structures, and rm with low business risk tend toward more highly leveraged capital structures.

Select correct answer from the options given below:

(A) (i) only

(B) (i) and (iii)

(D) All of the above

44. Which of the following is vulnerable to hostile takeovers?

(A) Horizontal Capital Structure

(B) Vertical Capital Structure

(D) All of the above

45. Floatation costs are those expenses which are incurred while -

(A) Issuing securities

(B) Repayment of debts

(D) Repayment of equity and debts

46. Operating/Business Risk refers to the risk of -

(A) Inability to pay xed nancial payments ( e.g. , payment of interest, preference dividend, return of the debt capital, etc.)

(B) Inability to discharge permanent operating costs ( e.g. , rent of the building, payment of salary, insurance instalment, etc.)

(D) None of the above

CAPITAL STRUCTURE 7.19 TAXMANN ®

CAPITAL STRUCTURE

47. Which of the following is floatation cost?

(A) Commission of underwriters

(B) Brokerage paid on issue of securities

(D) All of the above

48. _______ denotes the level of EBIT for which the firm’s EPS equals zero.

(A) Financial break-even point

(B) Margin of safety

(D) Min-max point

49. Which of the following is correct formula to calculate EPS?

(A) [(EBIT + I) (1 - T) - Dp]/N0

(B) [EBIT - I + T - Dp]/N0

(D) [(EBIT - I) (1 - T) + Dp]/N0

50. If the EBIT is less than the financial breakeven point, then the EPS will be -

(A) Positive

(B) Negative

(D) Maximum

51. According to Net Income Approach, capital structure decision -

(A) Is relevant to the value of the rm.

(B) Of the rm are irrelevant.

(D) Division between debt and equity is irrelevant.

52. According to Net Operating Income Approach -

(A) Capital structure decisions of the rm are irrelevant.

(B) Any change in the leverage will not lead to any change in the total value of the rm and the market price of

shares, as the overall cost of capital is independent of the degree of leverage.

(D) All of the above

53. According to ______, the firm can increase its total value by decreasing its overall cost of capital through increasing the degree of leverage.

(A) Net Operating Income Approach

(B) Net Income Approach

(D) Neither (A) nor (B)

54. As per Net Income Approach the value of the firm will be maximum at a point where -

(A) Average cost of equity is minimum.

(B) Average cost of debt is minimum.

(D) Weighted average cost of capital is minimum.

55. Any change in the leverage will not lead to any change in the total value of the firm and the market price of shares, as the overall cost of capital is independent of the degree of leverage. This is as per -

(A) Net Operating Income Approach

(B) Net Income Approach

(D) Neither (A) nor (B)

56. Inability to pay fixed financial payments

e.g . payment of interest, preference dividend, return of the debt capital, etc. is called as -

(A) Business risk

(B) Financial risk

(D) (A) and (C)

57. If expected level of EBIT is more than the breakeven point, then the EPS will be -

(A) Minimum

(B) Negative

7.20

TAXMANN

FINANCIAL & STRATEGIC MANAGEMENT (FSM | FM & SM) | MCQS

AUTHOR : N.S. ZAD , ASHISH PARIKH

PUBLISHER : TAXMANN

DATE OF PUBLICATION : JANUARY 2023

EDITION : 6th Edition

ISBN NO : 9789356225701

NO. OF PAGES : 740

BINDING TYPE : PAPERBACK

DESCRIPTION

Rs. 795 USD 41

This book is prepared exclusively for the Executive Level of Company Secretary Examination requirement. Each chapter covers problems & solutions along with multiple-choice questions (MCQs).

The Present Publication is the 6th Edition for CS-Executive | June/Dec. 2023 Exams. This book is authored by CS N.S. Zad & Prof. Ashish Parikh, with the following noteworthy features:

• Strictly as per the New Syllabus of ICSI

• [Comprehensive, Lucid & Systematic] presentation of theory, practical questions & MCQs

• [Coverage] of this book includes

• [2800+ MCQs] along with Problems & Solutions are covered in each chapter

• [Theory & Practical Based MCQs] with the following for complicated terms and mathematical calculations:

• Hints

• Working Notes

• Explanatory Notes

• [Fully Solved Questions of Past Exams], including:

• Solved Paper – December 2022 | New Syllabus

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