Test 1: Financing Decisions - Capital Structure: answer key

Question 1 · 2 marks · Financing Decisions - Capital Structure · medium

Scenario. Bharat Renewables Ltd. manufactures grid-scale battery modules and is evaluating whether to increase long-term borrowings to fund a new assembly line. Its order book is largely supported by multi-year power-storage contracts. Management expects operating earnings to remain reasonably stable, although the longer receivable cycle requires careful liquidity planning. The treasury team has prepared the following information for the finance committee. Financial and operating data (₹ lakh, except rates and days): Particular | Amount / rate Annual EBIT | 84.00 Existing market value of long-term debt | 240.00 Coupon rate on existing debt | 10.00% Corporate tax rate | 25.00% Equity beta | 1.50 Risk-free rate | 6.00% Expected market risk premium | 6.00% Annual cash flow after tax from operations, before financing | 96.00 Raw-material holding period | 40 days Work-in-process period | 12 days Finished-goods holding period | 28 days Receivables collection period | 55 days Trade-credit period | 35 days The resulting operating cycle, measured as the cash-conversion period, is relevant to the amount of short-term liquidity that must be maintained; it is not itself a component of the theoretical valuation equations below. For the classical Net Income (NI) and Net Operating Income (NOI) computations in this case, use the respective no-tax assumptions of those approaches, notwithstanding the statutory tax rate shown for cash-flow planning. The finance committee is also comparing four market-value capitalisation alternatives under the Traditional Approach. The percentages below represent debt as a proportion of total market value, not debt-equity ratios. Alternative | Debt weight | Kd | Ke A | 0% | Not applicable | 15.00% B | 20% | 9.00% | 16.00% C | 40% | 10.00% | 17.00% D | 60% | 13.00% | 21.00% The committee wants the analysis to distinguish the assumptions of the three classical approaches and identify the financing mix that minimises the overall capitalisation rate.

Using the Capital Asset Pricing Model, determine Bharat Renewables Ltd.'s required return on equity for appraisal purposes.

1. 12.00%
2. 15.00% (correct answer)
3. 9.00%
4. 18.00%

Answer: B — 15.00%

Explanation. CAPM gives Ke = Rf + β(Rm − Rf). The expected market risk premium is already given as 6%, so Ke = 6% + (1.50 × 6%) = 6% + 9% = 15%. The beta scales the market premium; it is not added to the risk-free rate as a percentage point on its own. Option c ignores beta, while option d overstates the premium by treating beta as 2.00. The answer is 15.00%.

Where it goes wrong. Using the market risk premium without multiplying it by beta, or multiplying the risk-free rate by beta.

Authority. ICAI SM: Financial Management and Strategic Management, Financing Decisions - Capital Structure

Question 2 · 2 marks · Financing Decisions - Capital Structure · hard

Applying the classical Net Income (NI) Approach to the existing financing, determine the market value of equity, total value of the firm and overall cost of capital. Use the CAPM-derived Ke from the case.

1. Equity ₹3,60,00,000; firm ₹6,00,00,000; Ko 14.00%
2. Equity ₹4,00,00,000; firm ₹6,40,00,000; Ko 14.00%
3. Equity ₹4,00,00,000; firm ₹6,40,00,000; Ko 13.125% (correct answer)
4. Equity ₹4,80,00,000; firm ₹7,20,00,000; Ko 11.67%

Answer: C — Equity ₹4,00,00,000; firm ₹6,40,00,000; Ko 13.125%

Explanation. Under NI, interest = ₹240 lakh × 10% = ₹24 lakh. Earnings available to equity (NI) = EBIT ₹84 lakh − ₹24 lakh = ₹60 lakh. Market value of equity S = NI/Ke = ₹60 lakh/15% = ₹400 lakh. Firm value V = S + D = ₹400 lakh + ₹240 lakh = ₹640 lakh. Overall capitalisation rate Ko = EBIT/V = ₹84/₹640 = 13.125%. Option b has the correct value but incorrectly reports 14% as Ko.

Where it goes wrong. Computing Ko using the stated Ke or using post-tax earnings, instead of EBIT divided by total firm value under the classical NI framework.

Authority. ICAI SM: Financial Management and Strategic Management, Financing Decisions - Capital Structure

Question 3 · 2 marks · Financing Decisions - Capital Structure · hard

Assume the board instead applies the Net Operating Income (NOI) Approach with an overall capitalisation rate of 14%. Based on the existing debt, what are the firm's value and implied cost of equity?

1. Firm value ₹6,00,00,000; Ke 16.67% (correct answer)
2. Firm value ₹6,40,00,000; Ke 15.00%
3. Firm value ₹5,60,00,000; Ke 18.00%
4. Firm value ₹6,00,00,000; Ke 14.00%

Answer: A — Firm value ₹6,00,00,000; Ke 16.67%

Explanation. Under NOI, total firm value is EBIT/Ko = ₹84 lakh/14% = ₹600 lakh. Equity value is V − D = ₹600 lakh − ₹240 lakh = ₹360 lakh. Interest is ₹24 lakh, so earnings available to equity are ₹84 lakh − ₹24 lakh = ₹60 lakh. Implied Ke = ₹60 lakh/₹360 lakh = 16.6667%, or 16.67%. Option d mistakes the constant overall rate for the cost of equity; NOI requires Ke to absorb the leverage risk.

Where it goes wrong. Treating the constant NOI capitalisation rate Ko as Ke, or valuing equity before deducting the market value of debt.

Authority. ICAI SM: Financial Management and Strategic Management, Financing Decisions - Capital Structure

Question 4 · 2 marks · Financing Decisions - Capital Structure · hard

Under the Traditional Approach, which capitalisation alternative minimises WACC and should be regarded as the optimal mix among the four alternatives presented?

1. Alternative B, with WACC of 14.60%
2. Alternative A, with WACC of 15.00%
3. Alternative D, with WACC of 16.20%
4. Alternative C, with WACC of 14.20% (correct answer)

Answer: D — Alternative C, with WACC of 14.20%

Explanation. Use market-value weights. A: full × 15% = 15.00%. B: (20% × 9%) + (80% × 16%) = 1.80% + 12.80% = 14.60%. C: (40% × 10%) + (60% × 17%) = 4.00% + 10.20% = 14.20%. D: (60% × 13%) + (40% × 21%) = 7.80% + 8.40% = 16.20%. Alternative C is lowest; beyond it, rising financing costs reverse the benefit of leverage.

Where it goes wrong. Using debt-equity ratio instead of debt-to-total-value weights, or assuming the highest debt proportion must always minimise WACC.

Authority. ICAI SM: Financial Management and Strategic Management, Financing Decisions - Capital Structure

Question 5 · 2 marks · Financing Decisions - Capital Structure · medium

Scenario. Zenith Auto Components Ltd. is expanding its precision-moulding facility to supply electric-vehicle manufacturers. The board has approved a long-term funding requirement and is comparing an all-equity plan with a plan combining ordinary shares, debentures and preference shares. Existing production contracts provide reasonable demand visibility, but customers negotiate extended credit periods and the company must retain adequate cash for inventory replenishment. The finance director has prepared the following estimates for the coming year. Operating and market data (₹ lakh, except per-share data, rates and days): Particular | Amount / rate Expected EBIT | 80.00 Corporate tax rate | 25.00% Risk-free rate | 6.00% Equity beta | 1.40 Expected market risk premium | 7.50% Annual cash flow after tax from operations, before financing | 140.00 Inventory holding period | 35 days Receivables collection period | 45 days Trade-payables period | 30 days Financing alternatives for the proposed facility: Particular | Plan A | Plan B Total ordinary equity shares after issue | 40 lakh shares | 20 lakh shares Annual debenture interest | Nil | ₹30 lakh Annual preference dividend | Nil | ₹15 lakh Plan B's fixed charges arise from ₹3 crore of 10% debentures and preference capital carrying a 10% annual dividend. For a separate market-value WACC appraisal of Plan B, the estimated market values are ordinary equity ₹800 lakh, debentures ₹300 lakh and preference shares ₹150 lakh. Assume the quoted debenture cost is before tax and preference dividend is not tax-deductible. The same ordinary equity beta applies to the proposed financing plan. Management expects EBIT could vary materially with automobile demand; it therefore wants the indifference point and financial break-even point assessed before relying on the EPS advantage of leverage. The cash-conversion period and operating cash generation are included to frame the liquidity and debt-servicing context, not as substitutes for EBIT in the EPS equations.

Calculate the EBIT indifference point between Plan A and Plan B, taking account of the preference dividend in Plan B.

1. ₹1,00,00,000 (correct answer)
2. ₹80,00,000
3. ₹1,20,00,000
4. ₹90,00,000

Answer: A — ₹1,00,00,000

Explanation. Plan A EPS = EBIT(1 − 0.25)/40 lakh. Plan B EPS = [(EBIT − ₹30 lakh)(0.75) − ₹15 lakh]/20 lakh. Equating and multiplying through: 0.75EBIT/40 = (0.75EBIT − 22.5 − 15)/20; hence 0.375EBIT = 0.75EBIT − 37.5, so 0.375EBIT = 37.5 and EBIT = ₹100 lakh. Preference dividend is deducted after tax, not before computing tax.

Where it goes wrong. Omitting preference dividend or deducting it before tax, even though preference dividend is not tax-deductible.

Authority. ICAI SM: Financial Management and Strategic Management, Financing Decisions - Capital Structure

Question 6 · 2 marks · Financing Decisions - Capital Structure · medium

Determine the financial break-even EBIT for Plan B of Zenith Auto Components Ltd.

1. ₹45,00,000
2. ₹38,00,000
3. ₹60,00,000
4. ₹50,00,000 (correct answer)

Answer: D — ₹50,00,000

Explanation. At financial break-even, earnings available to ordinary shareholders are zero. The required EBIT must cover interest and the pre-tax equivalent of preference dividend. Financial BEP = Interest + Preference dividend/(1 − tax rate) = ₹30 lakh + ₹15 lakh/0.75 = ₹30 lakh + ₹20 lakh = ₹50 lakh. The preference dividend is an after-tax appropriation, so it must be grossed up. Option a merely adds the two cash charges without the gross-up.

Where it goes wrong. Treating preference dividend like interest and deducting it before tax, rather than grossing it up by (1 − tax rate).

Authority. ICAI SM: Financial Management and Strategic Management, Financing Decisions - Capital Structure

Question 7 · 2 marks · Financing Decisions - Capital Structure · hard

At the expected EBIT of ₹80 lakh, which plan gives the higher EPS and what is that EPS?

1. Plan B; ₹1.50
2. Plan A; ₹1.50 (correct answer)
3. Plan B; ₹2.25
4. Plan A; ₹2.00

Answer: B — Plan A; ₹1.50

Explanation. Plan A earnings for equity = ₹80 lakh × 75% = ₹60 lakh; EPS = ₹60 lakh/40 lakh shares = ₹1.50. Plan B earnings for ordinary equity = (₹80 lakh − ₹30 lakh) × 75% − ₹15 lakh = ₹37.50 lakh − ₹15 lakh = ₹22.50 lakh; EPS = ₹22.50 lakh/20 lakh shares = ₹1.125. Therefore Plan A is superior at this EBIT, which is below the ₹100 lakh indifference point.

Where it goes wrong. Comparing earnings before preference dividend, or assuming the lower share count automatically makes the leveraged plan preferable at every EBIT level.

Authority. ICAI SM: Financial Management and Strategic Management, Financing Decisions - Capital Structure

Question 8 · 2 marks · Financing Decisions - Capital Structure · hard

Using CAPM and the market values supplied, calculate the WACC of Plan B. The debenture cost is 10% before tax and the corporate tax rate is 25%.

1. 12.96%
2. 14.20%
3. 13.56% (correct answer)
4. 15.00%

Answer: C — 13.56%

Explanation. CAPM Ke = 6% + (1.40 × 7.50%) = 16.50%. After-tax debt cost = 10% × (1 − 25%) = 7.50%. Preference cost = ₹15 lakh/₹150 lakh = 10%. Total market value = ₹800 + ₹300 + ₹150 = ₹1,250 lakh; weights are 64%, 24% and 12%. WACC = (16.5% × 64%) + (7.5% × 24%) + (10% × 12%) = 10.56% + 1.80% + 1.20% = 13.56%.

Where it goes wrong. Using book or issue amounts instead of market-value weights, or applying the tax shield to preference dividend as well as debt interest.

Authority. ICAI SM: Financial Management and Strategic Management, Financing Decisions - Capital Structure

Question 9 · 2 marks · Financing Decisions - Capital Structure · medium

Scenario. A company reports EBIT of ₹1,20,00,000 and has perpetual debt of ₹3,00,00,000 carrying 8% interest. Under the classical NI Approach, Ke is 16%. Determine the total value of the firm and its overall cost of capital.

A company reports EBIT of ₹1,20,00,000 and has perpetual debt of ₹3,00,00,000 carrying 8% interest. Under the classical NI Approach, Ke is 16%. Determine the total value of the firm and its overall cost of capital.

1. ₹7,50,00,000 and 16.00%
2. ₹10,50,00,000 and 11.43%
3. ₹8,40,00,000 and 14.29%
4. ₹9,00,00,000 and 13.33% (correct answer)

Answer: D — ₹9,00,00,000 and 13.33%

Explanation. Annual interest = ₹3 crore × 8% = ₹24 lakh. NI available to equity = ₹120 lakh − ₹24 lakh = ₹96 lakh. Market value of equity = ₹96 lakh/16% = ₹600 lakh. Add debt of ₹300 lakh to obtain firm value of ₹900 lakh. Overall cost of capital = EBIT/value of firm = ₹120 lakh/₹900 lakh = 13.333%, or 13.33%. The debt is added after valuing equity; it is not included in the equity capitalisation denominator.

Where it goes wrong. Dividing EBIT by Ke instead of dividing equity NI by Ke, or forgetting to add the market value of debt to equity value.

Authority. ICAI SM: Financial Management and Strategic Management, Financing Decisions - Capital Structure

Question 10 · 2 marks · Financing Decisions - Capital Structure · hard

Scenario. Under the NOI Approach, a firm has EBIT of ₹1,20,00,000, an overall capitalisation rate of 12%, debt of ₹3,00,00,000 at 8%, and no tax. What is the implied cost of equity?

Under the NOI Approach, a firm has EBIT of ₹1,20,00,000, an overall capitalisation rate of 12%, debt of ₹3,00,00,000 at 8%, and no tax. What is the implied cost of equity?

1. 13.71% (correct answer)
2. 12.00%
3. 16.00%
4. 10.50%

Answer: A — 13.71%

Explanation. NOI valuation gives total firm value V = EBIT/Ko = ₹120 lakh/12% = ₹1,000 lakh. Equity value S = V − D = ₹1,000 lakh − ₹300 lakh = ₹700 lakh. Interest = ₹300 lakh × 8% = ₹24 lakh, so equity earnings = ₹120 lakh − ₹24 lakh = ₹96 lakh. Therefore Ke = ₹96 lakh/₹700 lakh = 13.7143%, or 13.71%. Ko remains 12%; Ke rises to absorb the leverage risk.

Where it goes wrong. Reporting the constant overall capitalisation rate as Ke, or using EBIT rather than EBIT less interest for equity earnings.

Authority. ICAI SM: Financial Management and Strategic Management, Financing Decisions - Capital Structure

Question 11 · 2 marks · Financing Decisions - Capital Structure · hard

Scenario. A finance manager evaluates four structures under the Traditional Approach. The percentages are market-value debt weights and the stated Kd and Ke are applicable capitalisation rates. Identify the structure with the lowest WACC. P: Debt 20%, Kd 8%, Ke 15%. Q: Debt 40%, Kd 9%, Ke 15.5%. R: Debt 50%, Kd 11%, Ke 18%. S: Debt 60%, Kd 12%, Ke 20%.

A finance manager evaluates four structures under the Traditional Approach. The percentages are market-value debt weights and the stated Kd and Ke are applicable capitalisation rates. Identify the structure with the lowest WACC. P: Debt 20%, Kd 8%, Ke 15%. Q: Debt 40%, Kd 9%, Ke 15.5%. R: Debt 50%, Kd 11%, Ke 18%. S: Debt 60%, Kd 12%, Ke 20%.

1. Structure P
2. Structure R
3. Structure Q (correct answer)
4. Structure S

Answer: C — Structure Q

Explanation. Compute Ko = Kd × debt weight + Ke × equity weight. P = 8% × 20% + 15% × 80% = 13.60%. Q = 9% × 40% + 15.5% × 60% = 12.90%. R = 11% × 50% + 18% × 50% = 14.50%. S = 12% × 60% + 20% × 40% = 15.20%. Q has the minimum WACC. This reflects the Traditional Approach: leverage initially benefits the firm, but excessive debt eventually raises both debt and equity costs.

Where it goes wrong. Using the debt-equity ratio as the debt weight, or comparing Kd alone rather than weighting both sources in total capital.

Authority. ICAI SM: Financial Management and Strategic Management, Financing Decisions - Capital Structure

Question 12 · 2 marks · Financing Decisions - Capital Structure · medium

Scenario. A company has an unlevered cost of equity of 14%, a debt cost of 8%, and a debt-equity ratio of 1.5:1. Under the MM Approach without tax, determine the levered cost of equity.

A company has an unlevered cost of equity of 14%, a debt cost of 8%, and a debt-equity ratio of 1.5:1. Under the MM Approach without tax, determine the levered cost of equity.

1. 17.00%
2. 23.00% (correct answer)
3. 20.00%
4. 26.00%

Answer: B — 23.00%

Explanation. For MM without tax, Ke = Ku + (Ku − Kd)(D/E). Substituting: Ke = 14% + (14% − 8%) × 1.5 = 14% + 9% = 23%. The firm’s overall cost of capital remains unchanged at the business-risk rate, while equity holders require a premium for financial risk. Option a results from multiplying the spread by 0.5; option d overstates the debt-equity ratio effect.

Where it goes wrong. Substituting equity/debt instead of debt/equity, or incorrectly changing the overall cost of capital rather than the levered cost of equity.

Authority. ICAI SM: Financial Management and Strategic Management, Financing Decisions - Capital Structure

Question 13 · 2 marks · Financing Decisions - Capital Structure · hard

Scenario. An unlevered company is valued at ₹12 crore. A comparable company proposes permanent debt of ₹4 crore. If the corporate tax rate is 25%, what is the value of the levered company under the MM Approach with tax?

An unlevered company is valued at ₹12 crore. A comparable company proposes permanent debt of ₹4 crore. If the corporate tax rate is 25%, what is the value of the levered company under the MM Approach with tax?

1. ₹12.00 crore
2. ₹13.00 crore (correct answer)
3. ₹14.00 crore
4. ₹15.00 crore

Answer: B — ₹13.00 crore

Explanation. Under MM with corporate tax, value of levered firm = value of unlevered firm + tax shield. Tax shield = Debt × tax rate = ₹4 crore × 25% = ₹1 crore. Therefore VL = ₹12 crore + ₹1 crore = ₹13 crore. The calculation assumes the debt is permanent and that the tax shield is valued as debt multiplied by the corporate tax rate, consistent with the model stated in the chapter. Option a ignores the shield; option d applies a 75% benefit.

Where it goes wrong. Omitting the interest tax shield or applying the after-tax percentage to the unlevered firm value instead of to debt.

Authority. ICAI SM: Financial Management and Strategic Management, Financing Decisions - Capital Structure

Question 14 · 2 marks · Financing Decisions - Capital Structure · hard

Scenario. Under the MM Approach with tax, an unlevered company has Keu of 15%. A levered company has debt of ₹2,40,00,000, equity market value of ₹3,60,00,000, debt cost of 10% and corporate tax of 25%. Calculate its levered cost of equity.

Under the MM Approach with tax, an unlevered company has Keu of 15%. A levered company has debt of ₹2,40,00,000, equity market value of ₹3,60,00,000, debt cost of 10% and corporate tax of 25%. Calculate its levered cost of equity.

1. 16.67%
2. 18.33%
3. 20.00%
4. 17.50% (correct answer)

Answer: D — 17.50%

Explanation. For MM with tax, Keg = Keu + (Keu − Kd) × [D(1 − t)/E]. The adjusted debt-equity factor is ₹240 lakh × 75%/₹360 lakh = 0.50. Therefore Keg = 15% + (15% − 10%) × 0.50 = 15% + 2.50% = 17.50%. The tax adjustment is applied to debt in the numerator. Using unadjusted D/E would produce 18.33%, a common omission of the tax shield.

Where it goes wrong. Using D/E without multiplying debt by (1 − tax rate) in the MM-with-tax cost of equity formula.

Authority. ICAI SM: Financial Management and Strategic Management, Financing Decisions - Capital Structure

Question 15 · 2 marks · Financing Decisions - Capital Structure · medium

Scenario. Two financing plans are under consideration. Plan I has 40 lakh equity shares and no debt. Plan II has 30 lakh equity shares and annual interest of ₹20 lakh. Corporate tax is 30%. Determine the EBIT-EPS indifference point.

Two financing plans are under consideration. Plan I has 40 lakh equity shares and no debt. Plan II has 30 lakh equity shares and annual interest of ₹20 lakh. Corporate tax is 30%. Determine the EBIT-EPS indifference point.

1. ₹80,00,000 (correct answer)
2. ₹60,00,000
3. ₹1,00,00,000
4. ₹1,20,00,000

Answer: A — ₹80,00,000

Explanation. Equate EPS: [EBIT × 70%]/40 = [(EBIT − ₹20 lakh) × 70%]/30. The common tax factor cancels, giving EBIT/40 = (EBIT − 20)/30. Cross-multiplying: 30EBIT = 40EBIT − 800 (amounts in lakh); therefore 10EBIT = 800 and EBIT = ₹80 lakh. At this EBIT, both plans produce identical EPS. The after-tax factor cancels because both plans have the same tax rate and neither has preference dividends.

Where it goes wrong. Cancelling tax correctly but multiplying the interest amount by the wrong share denominator while cross-multiplying the equation.

Authority. ICAI SM: Financial Management and Strategic Management, Financing Decisions - Capital Structure

Question 16 · 2 marks · Financing Decisions - Capital Structure · hard

Scenario. A financing plan has annual interest of ₹18,00,000 and preference dividend of ₹15,00,000. If the corporate tax rate is 25%, calculate the financial break-even EBIT.

A financing plan has annual interest of ₹18,00,000 and preference dividend of ₹15,00,000. If the corporate tax rate is 25%, calculate the financial break-even EBIT.

1. ₹30,00,000
2. ₹33,00,000
3. ₹38,00,000 (correct answer)
4. ₹42,00,000

Answer: C — ₹38,00,000

Explanation. Financial break-even is the EBIT at which earnings available to ordinary shareholders are nil. Interest is deductible before tax, whereas preference dividend is paid out of post-tax earnings. Hence financial BEP = Interest + Preference dividend/(1 − t) = ₹18 lakh + ₹15 lakh/0.75 = ₹18 lakh + ₹20 lakh = ₹38 lakh. Option a adds the two fixed charges directly and misses the gross-up; option d over-grosses the dividend using the wrong tax factor.

Where it goes wrong. Adding preference dividend directly to interest without converting the dividend to its pre-tax equivalent.

Authority. ICAI SM: Financial Management and Strategic Management, Financing Decisions - Capital Structure

Question 17 · 2 marks · Financing Decisions - Capital Structure · hard

Scenario. A company has EBIT of ₹1,00,00,000 and annual interest of ₹25,00,000. Calculate the degree of financial leverage at this EBIT level, assuming no preference dividend.

A company has EBIT of ₹1,00,00,000 and annual interest of ₹25,00,000. Calculate the degree of financial leverage at this EBIT level, assuming no preference dividend.

1. 1.00 times
2. 1.25 times
3. 1.50 times
4. 1.33 times (correct answer)

Answer: D — 1.33 times

Explanation. Degree of financial leverage at a given EBIT = EBIT/EBT when there is no preference dividend. EBT = ₹1,00,00,000 − ₹25,00,000 = ₹75,00,000. DFL = ₹1,00,00,000/₹75,00,000 = 1.3333 times, or 1.33 times. The ratio measures the sensitivity of equity earnings to a change in EBIT. Option b comes from dividing EBIT by interest instead of by EBT.

Where it goes wrong. Using interest as the denominator rather than earnings before tax (EBIT less interest).

Authority. ICAI SM: Financial Management and Strategic Management, Financing Decisions - Capital Structure

Question 18 · 2 marks · Financing Decisions - Capital Structure · hard

Scenario. A company's market value of equity is ₹4 crore and market value of debt is ₹1 crore. Ke is 16%, pre-tax Kd is 10%, and the corporate tax rate is 30%. Calculate WACC using market-value weights.

A company's market value of equity is ₹4 crore and market value of debt is ₹1 crore. Ke is 16%, pre-tax Kd is 10%, and the corporate tax rate is 30%. Calculate WACC using market-value weights.

1. 14.20% (correct answer)
2. 15.00%
3. 13.00%
4. 14.80%

Answer: A — 14.20%

Explanation. Total market value = ₹5 crore. Equity weight = 4/5 = 80%; debt weight = 1/5 = 20%. After-tax debt cost = 10% × (1 − 30%) = 7%. WACC = (16% × 80%) + (7% × 20%) = 12.80% + 1.40% = 14.20%. The market values are specified because WACC should reflect the current capital mix relevant to firm value. Using the pre-tax debt cost would give 14.80%, which is not the required after-tax WACC.

Where it goes wrong. Using book-value weights or failing to apply the corporate tax shield to the cost of debt.

Authority. ICAI SM: Financial Management and Strategic Management, Financing Decisions - Capital Structure

Question 19 · 2 marks · Financing Decisions - Capital Structure · hard

Scenario. A company is considering increasing permanent debt from ₹4 crore to ₹6 crore. The corporate tax rate is 30%. The present value of expected financial distress costs is estimated to rise by ₹65 lakh because of the additional borrowing. What is the estimated incremental effect on firm value under a trade-off analysis?

A company is considering increasing permanent debt from ₹4 crore to ₹6 crore. The corporate tax rate is 30%. The present value of expected financial distress costs is estimated to rise by ₹65 lakh because of the additional borrowing. What is the estimated incremental effect on firm value under a trade-off analysis?

1. Increase of ₹65 lakh
2. Increase of ₹5 lakh
3. Decrease of ₹5 lakh (correct answer)
4. Decrease of ₹60 lakh

Answer: C — Decrease of ₹5 lakh

Explanation. Additional debt = ₹6 crore − ₹4 crore = ₹2 crore. Incremental interest tax shield value under the simplified permanent-debt model = ₹2 crore × 30% = ₹60 lakh. Incremental expected distress cost is ₹65 lakh. Net change in firm value = ₹60 lakh − ₹65 lakh = −₹5 lakh. Thus the extra borrowing reduces estimated value by ₹5 lakh; the firm should not increase debt on these assumptions. The calculation illustrates the trade-off between tax benefits and distress costs.

Where it goes wrong. Considering only the tax shield and ignoring the incremental expected financial distress cost.

Authority. ICAI SM: Financial Management and Strategic Management, Financing Decisions - Capital Structure

Question 20 · 2 marks · Financing Decisions - Capital Structure · hard

Scenario. A company uses a capital structure that produces a WACC of 12%. A project requires an initial outlay of ₹2,50,00,000 and is expected to generate CFAT of ₹1,00,00,000 at each year-end for three years, together with salvage proceeds of ₹30,00,000 at the end of Year 3. The relevant factors are PVAF(12%, 3 years) = 2.402 and PVIF(12%, 3 years) = 0.712. What is the NPV and decision?

A company uses a capital structure that produces a WACC of 12%. A project requires an initial outlay of ₹2,50,00,000 and is expected to generate CFAT of ₹1,00,00,000 at each year-end for three years, together with salvage proceeds of ₹30,00,000 at the end of Year 3. The relevant factors are PVAF(12%, 3 years) = 2.402 and PVIF(12%, 3 years) = 0.712. What is the NPV and decision?

1. Negative ₹11,56,000; reject
2. Positive ₹11,56,000; accept (correct answer)
3. Positive ₹21,36,000; accept
4. Positive ₹36,56,000; accept

Answer: B — Positive ₹11,56,000; accept

Explanation. PV of annual CFAT = ₹100 lakh × 2.402 = ₹240.20 lakh. PV of salvage = ₹30 lakh × 0.712 = ₹21.36 lakh. Total present value of inflows = ₹261.56 lakh. NPV = ₹261.56 lakh − ₹250 lakh = ₹11.56 lakh, which is positive; therefore accept the project. WACC is used as the discount rate because it represents the weighted financing cost for the project’s risk. Option c omits the annual operating inflows and considers only salvage value.

Where it goes wrong. Discounting accounting profit instead of CFAT, or omitting the initial investment or terminal salvage value from the NPV computation.

Authority. ICAI SM: Financial Management and Strategic Management, Financing Decisions - Capital Structure