Test 2: Financing Decisions - Capital Structure: answer key

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

Scenario. Aster Energy Storage Ltd. and Beacon Grid Systems Ltd. operate in the same battery-storage industry and have identical business risk, although their financing structures differ. Aster employs permanent debt financing, whereas Beacon is entirely equity financed. An institutional investor is reviewing a possible arbitrage opportunity arising from the difference in their current market valuations. The following information is available: Particulars | Aster Energy Storage Ltd. | Beacon Grid Systems Ltd. Annual EBIT (NOI) | ₹60 lakh | ₹60 lakh Market value of debt | ₹200 lakh | Nil Interest rate on debt | 10% | Not applicable Quoted market value of equity | ₹250 lakh | ₹400 lakh Market value of total firm | ₹450 lakh | ₹400 lakh Unlevered cost of capital (Ko) | 15% | 15% Unlevered business beta | 1.80 | 1.80 Risk-free rate | 6% | 6% Expected market risk premium | 5% | 5% Corporate tax rate for statutory reporting | 25% | 25% Annual operating cash flow before financing | ₹72 lakh | ₹72 lakh For the MM calculations in this case, assume a perfect capital market, no corporate taxes, no transaction costs and a full dividend payout ratio. The statutory tax rate is supplied only for the company's practical financial planning and must not be applied to the no-tax MM calculations. Aster's management is concerned that its quoted total market value may not be consistent with the value predicted by MM Proposition I. An investor currently owns 10% of Aster's equity shares and is considering selling the holding, borrowing a proportionate amount personally and investing in Beacon's shares. Personal borrowing is available at the same interest rate as Aster's corporate debt. Operational information for liquidity planning is as follows: Raw-material holding period: 40 days Work-in-process period: 10 days Finished-goods holding period: 20 days Receivables collection period: 55 days Trade-credit period: 35 days The finance department has calculated the business operating cycle separately from the cash-conversion period. The board wants to understand whether homemade leverage and arbitrage can eliminate the valuation difference without changing the investor's underlying financial return.

According to MM Proposition I without taxes, calculate the theoretical value of Aster Energy Storage Ltd. using the information supplied. What should be the value of the levered firm in equilibrium?

1. ₹450 lakh
2. ₹360 lakh
3. ₹400 lakh (correct answer)
4. ₹500 lakh

Answer: C — ₹400 lakh

Explanation. Under MM Proposition I without taxes, the value of the levered firm equals the value of the unlevered firm. Value of the unlevered firm = NOI/Ko = ₹60 lakh/15% = ₹400 lakh. Therefore, the theoretical equilibrium value of Aster, despite its debt financing, is also ₹400 lakh. Its current quoted value of ₹450 lakh represents a departure from MM equilibrium. Option a simply repeats the current quoted market value rather than the theoretical value.

Where it goes wrong. Confusing the existing quoted market value with the theoretical equilibrium value prescribed by MM Proposition I.

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

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

An investor owns 10% of Aster's equity. Calculate the surplus cash available after implementing the homemade leverage strategy by selling the shares, borrowing 10% of Aster's corporate debt and purchasing 10% of Beacon's shares. Also determine the annual income after the transaction.

1. Surplus ₹5 lakh; annual income ₹4 lakh (correct answer)
2. Surplus ₹2 lakh; annual income ₹4 lakh
3. Surplus ₹5 lakh; annual income ₹6 lakh
4. Surplus ₹20 lakh; annual income ₹4 lakh

Answer: A — Surplus ₹5 lakh; annual income ₹4 lakh

Explanation. Step 1: Value of Aster shares sold = 10% × ₹250 lakh = ₹25 lakh. Step 2: Personal borrowing = 10% × ₹200 lakh = ₹20 lakh. Total resources = ₹45 lakh. Step 3: Investment in Beacon = 10% × ₹400 lakh = ₹40 lakh. Surplus = ₹5 lakh. Step 4: Beacon earnings attributable to 10% ownership = ₹6 lakh; personal interest = ₹20 lakh × 10% = ₹2 lakh. Net annual income = ₹4 lakh, equal to the original 10% share of Aster's ₹40 lakh equity earnings.

Where it goes wrong. Borrowing the wrong proportion of corporate debt or treating the gross income from unlevered shares as the investor's net income without deducting personal interest.

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

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

At theoretical equilibrium, assume Aster has a total firm value of ₹400 lakh and retains debt of ₹200 lakh. Using MM Proposition II without taxes, calculate the required cost of equity if the cost of debt is 10%.

1. 15.00%
2. 18.00%
3. 25.00%
4. 20.00% (correct answer)

Answer: D — 20.00%

Explanation. Under MM Proposition II without taxes, Ke = Ko + (Ko − Kd) × D/E. Market value of equity = ₹400 lakh − ₹200 lakh = ₹200 lakh. Therefore, D/E = 200/200 = 1. Substituting, Ke = 15% + (15% − 10%) × 1 = 15% + 5% = 20%. This demonstrates that financial leverage increases the cost of equity even though the overall cost of capital remains constant.

Where it goes wrong. Using D/V instead of D/E in the MM Proposition II formula or incorrectly assuming that the cost of equity remains equal to the unlevered cost.

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

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

Based on MM Proposition I, calculate the absolute overvaluation of Aster Energy Storage Ltd. in its present market quotation and express that overvaluation as a percentage of its theoretical equilibrium value.

1. ₹40 lakh; 10%
2. ₹50 lakh; 12.50% (correct answer)
3. ₹60 lakh; 15%
4. ₹45 lakh; 11.25%

Answer: B — ₹50 lakh; 12.50%

Explanation. The theoretical equilibrium value under MM Proposition I is the unlevered value: ₹60 lakh/15% = ₹400 lakh. Present quoted firm value = ₹450 lakh. Absolute overvaluation = ₹450 lakh − ₹400 lakh = ₹50 lakh. Percentage overvaluation = ₹50 lakh/₹400 lakh × 100 = 12.50%. Arbitrageurs have an incentive to sell the relatively overvalued levered securities and substitute personal borrowing with shares of the unlevered firm until valuation equilibrium is restored.

Where it goes wrong. Calculating the percentage difference using the current quoted value as the denominator instead of the theoretical equilibrium value.

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

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

Scenario. Aditya Automotive Ltd. manufactures precision components for electric vehicles and conventional automobile manufacturers. Its management is evaluating the benefits of increasing permanent debt financing against the potential increase in financial distress and agency costs. The company has a reasonably established customer base, but its working capital requirements have increased due to longer collection periods from automobile manufacturers. The finance department has provided the following data: Particulars | Amount / Rate Annual EBIT | ₹120 lakh Corporate tax rate | 30% Unlevered cost of equity | 15% Existing permanent market value of debt | ₹200 lakh Existing debt interest rate | 10% Annual operating cash flow after tax, before financing | ₹100 lakh For the MM valuation exercise, assume debt is permanent and the tax shield can be valued at debt multiplied by the corporate tax rate. The unlevered firm has the same business risk as the proposed levered firm. Management is considering an additional permanent debt issue of ₹100 lakh. The estimated incremental present value of financial distress costs is ₹18 lakh, while additional agency costs arising from conflicts between shareholders and debt holders are estimated at ₹17 lakh. The board is also considering an independent expansion project requiring ₹150 lakh. The following financing resources are available: Retained earnings available for investment | ₹45 lakh Available secured borrowing capacity | ₹70 lakh External equity financing | Available for the remaining requirement Operational information relevant to liquidity planning: Raw-material holding period | 35 days Work-in-process period | 15 days Finished-goods holding period | 25 days Receivables collection period | 65 days Trade-payables period | 40 days The finance director wishes to distinguish between the tax advantage under the MM Approach with corporate taxes, the practical optimal debt level under Trade-off Theory and the financing hierarchy prescribed by Pecking Order Theory. All distress and agency cost estimates are present values, and the funding alternatives for the expansion project are independent of the additional-debt valuation exercise.

Calculate the present value of the interest tax shield attributable to Aditya Automotive Ltd.'s existing permanent debt under the MM Approach with corporate taxes.

1. ₹40 lakh
2. ₹20 lakh
3. ₹80 lakh
4. ₹60 lakh (correct answer)

Answer: D — ₹60 lakh

Explanation. Under the simplified MM model with permanent debt, the present value of the interest tax shield is Debt × Corporate tax rate. Existing permanent debt = ₹200 lakh and tax rate = 30%. Therefore, tax shield = ₹200 lakh × 30% = ₹60 lakh. This is the incremental value attributable to debt financing relative to the unlevered firm. Option a incorrectly uses the debt interest rate or an incomplete tax adjustment instead of the statutory tax rate.

Where it goes wrong. Using the coupon interest rate instead of the corporate tax rate in calculating the present value of the permanent-debt tax shield.

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

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

Calculate the total market value of Aditya Automotive Ltd. under the MM Approach with corporate taxes, considering its existing capital structure.

1. ₹620 lakh (correct answer)
2. ₹600 lakh
3. ₹680 lakh
4. ₹560 lakh

Answer: A — ₹620 lakh

Explanation. First calculate the unlevered firm value using Vu = EBIT(1 − t)/Keu. Vu = ₹120 lakh × 70%/15% = ₹84 lakh/15% = ₹560 lakh. Next calculate the debt tax shield = ₹200 lakh × 30% = ₹60 lakh. Therefore, levered firm value VL = Vu + Dt = ₹560 lakh + ₹60 lakh = ₹620 lakh. The corporate tax shield increases firm value over the unlevered position. Option d represents only the unlevered firm's value.

Where it goes wrong. Adding the debt tax shield to EBIT-based valuation without first calculating the after-tax unlevered operating income.

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

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

Aditya Automotive Ltd. proposes to increase permanent debt by ₹100 lakh. Determine the estimated net change in firm value after considering the incremental tax shield, financial distress cost and agency cost.

1. Increase of ₹5 lakh
2. Increase of ₹35 lakh
3. Decrease of ₹5 lakh (correct answer)
4. Decrease of ₹30 lakh

Answer: C — Decrease of ₹5 lakh

Explanation. Incremental permanent debt = ₹100 lakh. Additional tax benefit = ₹100 lakh × 30% = ₹30 lakh. Total incremental costs = Financial distress costs ₹18 lakh + Agency costs ₹17 lakh = ₹35 lakh. Net change in firm value = ₹30 lakh − ₹35 lakh = −₹5 lakh. Therefore, the proposed debt increase reduces estimated value by ₹5 lakh. Under Trade-off Theory, the tax benefit must be evaluated against both distress and agency costs rather than considered in isolation.

Where it goes wrong. Considering only the MM tax shield and ignoring financial distress costs and agency costs when evaluating additional borrowing.

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

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

Applying Pecking Order Theory to Aditya Automotive Ltd.'s independent ₹150 lakh expansion project, calculate the additional external equity required after utilising retained earnings and available secured debt in the prescribed order.

1. ₹70 lakh
2. ₹35 lakh (correct answer)
3. ₹45 lakh
4. ₹105 lakh

Answer: B — ₹35 lakh

Explanation. Pecking Order Theory gives priority to internal funds, followed by debt and finally external equity. Total project requirement = ₹150 lakh. First, retained earnings used = ₹45 lakh. Remaining requirement = ₹150 lakh − ₹45 lakh = ₹105 lakh. Secured debt utilised = ₹70 lakh. Final funding gap = ₹105 lakh − ₹70 lakh = ₹35 lakh. Hence, external equity of ₹35 lakh is required as the last financing source.

Where it goes wrong. Issuing equity before exhausting available internal finance and debt, contrary to the financing hierarchy under Pecking Order Theory.

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

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

Scenario. Two companies have identical operating risk and generate annual NOI of ₹90 lakh. The appropriate capitalisation rate for their risk class is 15%. One company is financed entirely through equity, while the other has permanent debt of ₹250 lakh. Assuming no corporate taxes and perfect capital markets, calculate the total market value of the levered company according to MM Proposition I.

Two companies have identical operating risk and generate annual NOI of ₹90 lakh. The appropriate capitalisation rate for their risk class is 15%. One company is financed entirely through equity, while the other has permanent debt of ₹250 lakh. Assuming no corporate taxes and perfect capital markets, calculate the total market value of the levered company according to MM Proposition I.

1. ₹600 lakh (correct answer)
2. ₹750 lakh
3. ₹350 lakh
4. ₹450 lakh

Answer: A — ₹600 lakh

Explanation. The MM Proposition I without taxes states that the market value of the levered company equals that of the unlevered company. Unlevered firm value = NOI/Ko = ₹90 lakh/15% = ₹600 lakh. Therefore, levered firm value must also be ₹600 lakh, regardless of the ₹250 lakh debt component. The corresponding theoretical equity value would be ₹600 lakh − ₹250 lakh = ₹350 lakh. Option c is equity value, not total firm value.

Where it goes wrong. Confusing the equity market value with total firm value while applying the irrelevance proposition.

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

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

Scenario. A company has an unlevered cost of equity of 16% and a pre-tax cost of debt of 10%. Its debt-equity ratio is 1.25:1. Assuming no corporate taxes, calculate the levered cost of equity under MM Proposition II.

A company has an unlevered cost of equity of 16% and a pre-tax cost of debt of 10%. Its debt-equity ratio is 1.25:1. Assuming no corporate taxes, calculate the levered cost of equity under MM Proposition II.

1. 21.00%
2. 23.50% (correct answer)
3. 19.75%
4. 26.00%

Answer: B — 23.50%

Explanation. MM Proposition II without taxes: Ke = Ku + (Ku − Kd) × D/E. Substituting the figures, Ke = 16% + (16% − 10%) × 1.25 = 16% + 7.50% = 23.50%. Thus, the cost of equity increases because equity shareholders bear additional financial risk. The overall capitalisation rate remains at 16% under the assumptions of the model. Option a understates the financial risk premium by using a debt-equity ratio of 0.833 instead of 1.25.

Where it goes wrong. Inverting the debt-equity ratio or confusing the levered cost of equity with the unchanged overall cost of capital.

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

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

Scenario. Two identical firms, Levered Ltd. and Unlevered Ltd., have NOI of ₹75 lakh and an overall capitalisation rate of 15%. Levered Ltd. has debt of ₹250 lakh bearing interest at 8%. An investor owns 4% of Levered Ltd.'s equity. Under MM assumptions without taxes, the investor sells the holding and borrows an amount equal to 4% of corporate debt to purchase a corresponding position in Unlevered Ltd. Calculate the investor's annual income after switching.

Two identical firms, Levered Ltd. and Unlevered Ltd., have NOI of ₹75 lakh and an overall capitalisation rate of 15%. Levered Ltd. has debt of ₹250 lakh bearing interest at 8%. An investor owns 4% of Levered Ltd.'s equity. Under MM assumptions without taxes, the investor sells the holding and borrows an amount equal to 4% of corporate debt to purchase a corresponding position in Unlevered Ltd. Calculate the investor's annual income after switching.

1. ₹3.00 lakh
2. ₹1.80 lakh
3. ₹2.20 lakh (correct answer)
4. ₹2.50 lakh

Answer: C — ₹2.20 lakh

Explanation. Unlevered value = ₹75 lakh/15% = ₹500 lakh. Under MM equilibrium, Levered equity value = ₹500 lakh − ₹250 lakh = ₹250 lakh. Interest on corporate debt = ₹250 lakh × 8% = ₹20 lakh. Earnings for levered equity = ₹75 lakh − ₹20 lakh = ₹55 lakh. Investor's original return = 4% × ₹55 lakh = ₹2.20 lakh. After switching, return on unlevered shares = 4% × ₹75 lakh = ₹3 lakh. Personal borrowing = 4% × ₹250 lakh = ₹10 lakh; interest = ₹0.80 lakh. Net income = ₹2.20 lakh.

Where it goes wrong. Failing to deduct interest on personal borrowing when recreating corporate leverage through the investor's own borrowing.

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

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

Scenario. Unlevered Ltd. and Levered Ltd. have identical business risk and annual NOI of ₹90 lakh. The unlevered cost of capital is 15%. Levered Ltd. has debt of ₹300 lakh at 10% interest and quoted equity value of ₹360 lakh. An investor owns 5% of Levered Ltd.'s equity. If the investor sells the shares, borrows 5% of corporate debt and invests in 5% of Unlevered Ltd., determine the surplus cash retained and annual income after switching.

Unlevered Ltd. and Levered Ltd. have identical business risk and annual NOI of ₹90 lakh. The unlevered cost of capital is 15%. Levered Ltd. has debt of ₹300 lakh at 10% interest and quoted equity value of ₹360 lakh. An investor owns 5% of Levered Ltd.'s equity. If the investor sells the shares, borrows 5% of corporate debt and invests in 5% of Unlevered Ltd., determine the surplus cash retained and annual income after switching.

1. Surplus ₹1.50 lakh; income ₹3.00 lakh
2. Surplus ₹4.50 lakh; income ₹4.50 lakh
3. Surplus ₹3.00 lakh; income ₹4.50 lakh
4. Surplus ₹3.00 lakh; income ₹3.00 lakh (correct answer)

Answer: D — Surplus ₹3.00 lakh; income ₹3.00 lakh

Explanation. Unlevered value = ₹90 lakh/15% = ₹600 lakh. Levered equity is quoted at ₹360 lakh, and 5% of this holding is worth ₹18 lakh. Personal borrowing = 5% × ₹300 lakh = ₹15 lakh. Total resources = ₹33 lakh. Investment in Unlevered Ltd. = 5% × ₹600 lakh = ₹30 lakh. Surplus = ₹3 lakh. Annual income from shares = 5% × ₹90 lakh = ₹4.50 lakh. Personal interest = ₹15 lakh × 10% = ₹1.50 lakh. Net income = ₹3 lakh, equal to the investor's original income from levered shares.

Where it goes wrong. Using the quoted market value of the levered company to determine the unlevered investment requirement instead of using the theoretical value of the unlevered company.

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

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

Scenario. A company has permanent debt of ₹450 lakh. The corporate income tax rate is 30%. Under the MM Approach with corporate taxes, calculate the present value of the tax advantage created by this debt financing.

A company has permanent debt of ₹450 lakh. The corporate income tax rate is 30%. Under the MM Approach with corporate taxes, calculate the present value of the tax advantage created by this debt financing.

1. ₹135 lakh (correct answer)
2. ₹90 lakh
3. ₹450 lakh
4. ₹315 lakh

Answer: A — ₹135 lakh

Explanation. Under MM with corporate taxes, the tax advantage of permanent debt equals D × t. Debt = ₹450 lakh and corporate tax = 30%. Therefore, tax shield = ₹450 lakh × 30% = ₹135 lakh. This amount represents the increase in firm value attributable to the tax deductibility of interest, assuming permanent debt and the model's stated valuation assumptions. Option d incorrectly applies the post-tax factor of 70% rather than the tax rate itself.

Where it goes wrong. Using debt multiplied by (1 − tax rate) instead of debt multiplied by the corporate tax rate to calculate the tax shield.

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

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

Scenario. An unlevered company's cost of equity is 18%. A comparable levered company has debt representing 40% of its total market value. If corporate tax is 25%, determine the WACC of the levered company using the MM Approach with taxes.

An unlevered company's cost of equity is 18%. A comparable levered company has debt representing 40% of its total market value. If corporate tax is 25%, determine the WACC of the levered company using the MM Approach with taxes.

1. 16.80%
2. 16.20% (correct answer)
3. 15.00%
4. 18.00%

Answer: B — 16.20%

Explanation. Under the MM-with-tax formula, Kog = Keu[1 − (t × L)], where L = D/(D + E). Here, Keu = 18%, t = 25% and L = 40%. Therefore, Kog = 18% × [1 − (0.25 × 0.40)] = 18% × 0.90 = 16.20%. The tax shield reduces the overall cost of capital relative to the unlevered cost. Option d ignores the corporate tax advantage of debt financing.

Where it goes wrong. Using the debt-equity ratio instead of the debt proportion of total firm value in the MM WACC formula.

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

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

Scenario. An unlevered company has a cost of equity of 20%. A levered company has debt of ₹300 lakh and equity of ₹450 lakh. Its cost of debt is 12% and corporate tax rate is 25%. Calculate the cost of equity of the levered company according to MM Proposition II with corporate taxes.

An unlevered company has a cost of equity of 20%. A levered company has debt of ₹300 lakh and equity of ₹450 lakh. Its cost of debt is 12% and corporate tax rate is 25%. Calculate the cost of equity of the levered company according to MM Proposition II with corporate taxes.

1. 22.00%
2. 26.00%
3. 24.00% (correct answer)
4. 25.00%

Answer: C — 24.00%

Explanation. The MM-with-tax formula is Keg = Keu + (Keu − Kd) × [D(1 − t)/E]. Adjusted debt = ₹300 lakh × 75% = ₹225 lakh. Adjusted D/E = ₹225 lakh/₹450 lakh = 0.50. Therefore, Keg = 20% + (20% − 12%) × 0.50 = 20% + 4% = 24%. The tax adjustment reduces the effective financial risk premium compared with the no-tax formula.

Where it goes wrong. Applying the no-tax D/E formula without adjusting debt for the corporate tax shield.

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

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

Scenario. A company generates annual EBIT of ₹160 lakh. Its corporate tax rate is 25%, unlevered cost of equity is 16% and permanent debt is ₹240 lakh. Calculate the market value of the levered company under MM Proposition I with corporate taxes.

A company generates annual EBIT of ₹160 lakh. Its corporate tax rate is 25%, unlevered cost of equity is 16% and permanent debt is ₹240 lakh. Calculate the market value of the levered company under MM Proposition I with corporate taxes.

1. ₹750 lakh
2. ₹870 lakh
3. ₹790 lakh
4. ₹810 lakh (correct answer)

Answer: D — ₹810 lakh

Explanation. Step 1: Unlevered value Vu = EBIT(1 − t)/Keu = ₹160 lakh × 75%/16% = ₹120 lakh/16% = ₹750 lakh. Step 2: Present value of permanent debt tax shield = ₹240 lakh × 25% = ₹60 lakh. Step 3: Levered value VL = Vu + Dt = ₹750 lakh + ₹60 lakh = ₹810 lakh. Option a gives only the unlevered company value and ignores the incremental tax benefit.

Where it goes wrong. Calculating the unlevered value correctly but forgetting to add the present value of the interest tax shield.

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

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

Scenario. A company proposes additional permanent debt of ₹100 lakh at a corporate tax rate of 30%. The resulting incremental present value of financial distress costs is ₹18 lakh and incremental agency costs are ₹7 lakh. Calculate the incremental change in company value under Trade-off Theory.

A company proposes additional permanent debt of ₹100 lakh at a corporate tax rate of 30%. The resulting incremental present value of financial distress costs is ₹18 lakh and incremental agency costs are ₹7 lakh. Calculate the incremental change in company value under Trade-off Theory.

1. Increase of ₹5 lakh (correct answer)
2. Decrease of ₹15 lakh
3. Increase of ₹30 lakh
4. Decrease of ₹25 lakh

Answer: A — Increase of ₹5 lakh

Explanation. Incremental tax shield = Additional debt × tax rate = ₹100 lakh × 30% = ₹30 lakh. Incremental distress costs = ₹18 lakh. Incremental agency costs = ₹7 lakh. Total incremental costs = ₹18 lakh + ₹7 lakh = ₹25 lakh. Net increase in firm value = ₹30 lakh − ₹25 lakh = ₹5 lakh. Therefore, the proposal creates an estimated positive value addition of ₹5 lakh, although further borrowing must still be assessed for future marginal costs.

Where it goes wrong. Deducting only financial distress costs while ignoring agency costs, or incorrectly treating the tax benefit as an additional cost.

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

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

Scenario. A company with an unlevered value of ₹800 lakh is evaluating four permanent debt alternatives. The corporate tax rate is 25%. All distress and agency cost estimates are present values. Alternative A: Debt ₹100 lakh; distress costs ₹8 lakh; agency costs ₹2 lakh. Alternative B: Debt ₹200 lakh; distress costs ₹14 lakh; agency costs ₹6 lakh. Alternative C: Debt ₹300 lakh; distress costs ₹28 lakh; agency costs ₹12 lakh. Alternative D: Debt ₹400 lakh; distress costs ₹48 lakh; agency costs ₹20 lakh. Which alternative maximises the estimated value of the company under Trade-off Theory?

A company with an unlevered value of ₹800 lakh is evaluating four permanent debt alternatives. The corporate tax rate is 25%. All distress and agency cost estimates are present values. Alternative A: Debt ₹100 lakh; distress costs ₹8 lakh; agency costs ₹2 lakh. Alternative B: Debt ₹200 lakh; distress costs ₹14 lakh; agency costs ₹6 lakh. Alternative C: Debt ₹300 lakh; distress costs ₹28 lakh; agency costs ₹12 lakh. Alternative D: Debt ₹400 lakh; distress costs ₹48 lakh; agency costs ₹20 lakh. Which alternative maximises the estimated value of the company under Trade-off Theory?

1. Alternative A; ₹815 lakh
2. Alternative C; ₹835 lakh (correct answer)
3. Alternative D; ₹832 lakh
4. Alternative B; ₹830 lakh

Answer: B — Alternative C; ₹835 lakh

Explanation. Estimated levered value = Vu + Debt × tax rate − distress costs − agency costs. A = 800 + 25 − 8 − 2 = ₹815 lakh. B = 800 + 50 − 14 − 6 = ₹830 lakh. C = 800 + 75 − 28 − 12 = ₹835 lakh. D = 800 + 100 − 48 − 20 = ₹832 lakh. Alternative C produces the highest firm value. Although Alternative D provides the largest tax shield, its higher distress and agency costs reduce its net benefit.

Where it goes wrong. Selecting the highest debt alternative solely because it provides the largest tax shield without deducting the increasing costs of financial distress and agency conflicts.

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

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

Scenario. A manufacturing company requires ₹160 lakh for an expansion project. It has ₹45 lakh of internal funds, secured debt capacity of ₹60 lakh, unsecured debt capacity of ₹25 lakh and access to hybrid debt of ₹15 lakh. Following the Pecking Order Theory, calculate the external equity financing that must be raised.

A manufacturing company requires ₹160 lakh for an expansion project. It has ₹45 lakh of internal funds, secured debt capacity of ₹60 lakh, unsecured debt capacity of ₹25 lakh and access to hybrid debt of ₹15 lakh. Following the Pecking Order Theory, calculate the external equity financing that must be raised.

1. ₹60 lakh
2. ₹30 lakh
3. ₹15 lakh (correct answer)
4. ₹45 lakh

Answer: C — ₹15 lakh

Explanation. Pecking Order Theory prioritises internal finance, followed by debt financing and ultimately external equity. Internal funds utilised = ₹45 lakh. Remaining requirement = ₹160 lakh − ₹45 lakh = ₹115 lakh. Debt utilised in sequence: secured ₹60 lakh + unsecured ₹25 lakh + hybrid ₹15 lakh = ₹100 lakh. Remaining requirement = ₹115 lakh − ₹100 lakh = ₹15 lakh. Hence, external equity of ₹15 lakh is the final financing requirement.

Where it goes wrong. Issuing equity before using available debt sources or incorrectly treating the secured debt limit as the total debt financing capacity.

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

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

Scenario. A company requires ₹90 lakh for a new manufacturing facility. Its available internal funds are ₹25 lakh. The company can raise secured debt of ₹30 lakh, unsecured debt of ₹20 lakh and hybrid debt of ₹10 lakh. Any remaining requirement must be financed by issuing equity shares at ₹250 per share. Following Pecking Order Theory, calculate the number of new equity shares to be issued.

A company requires ₹90 lakh for a new manufacturing facility. Its available internal funds are ₹25 lakh. The company can raise secured debt of ₹30 lakh, unsecured debt of ₹20 lakh and hybrid debt of ₹10 lakh. Any remaining requirement must be financed by issuing equity shares at ₹250 per share. Following Pecking Order Theory, calculate the number of new equity shares to be issued.

1. 4,000 shares
2. 3,000 shares
3. 1,000 shares
4. 2,000 shares (correct answer)

Answer: D — 2,000 shares

Explanation. First use internal funds of ₹25 lakh. Remaining requirement = ₹90 lakh − ₹25 lakh = ₹65 lakh. Next, utilise secured debt ₹30 lakh, unsecured debt ₹20 lakh and hybrid debt ₹10 lakh. Total debt financing = ₹60 lakh. Residual equity requirement = ₹65 lakh − ₹60 lakh = ₹5 lakh. Number of shares = ₹5,00,000/₹250 = 2,000 shares. Equity is raised only after the available internal and debt sources have been utilised.

Where it goes wrong. Calculating the number of shares using the total project requirement rather than the residual requirement after applying the pecking-order financing hierarchy.

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