Test 4: Financing Decisions - Capital Structure: answer key

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

Scenario. Bharat Renewables Ltd. manufactures solar modules and battery storage equipment. The company plans to expand its manufacturing capacity and is reviewing the implications of its existing financing structure. The finance director is particularly concerned about maintaining debt-servicing capacity, preserving promoter control and retaining flexibility to refinance expensive borrowings when market conditions improve. The following financial information is available: Particulars | Amount / Rate Annual EBIT | ₹96 lakh Existing equity shares | 12 lakh shares Promoters' existing shareholding | 7.20 lakh shares Existing long-term debt | ₹200 lakh Interest rate on existing debt | 14% Preference share capital | ₹60 lakh Preference dividend rate | 15% Corporate tax rate | 25% Equity beta | 1.20 Risk-free rate | 6% Expected market risk premium | 5.50% Annual cash flow available for debt servicing | ₹100 lakh Scheduled annual principal repayment | ₹32 lakh The company is considering issuing 6 lakh additional equity shares or raising additional debt. The proposed equity issue would be entirely subscribed by outside investors. Alternatively, the company can refinance its existing ₹200 lakh debt at 11% instead of its present 14% coupon rate. Assume there are no refinancing transaction costs for the interest-saving calculation. Operational details: Raw-material holding period: 35 days Work-in-process period: 10 days Finished-goods holding period: 25 days Receivables collection period: 60 days Trade-credit period: 30 days The company has a relatively stable order book, but its cash collections are concentrated in the final quarter of the financial year. The finance director must therefore evaluate the effect of fixed financial commitments under both normal and adverse operating conditions. The board also requires that any proposed financing arrangement should preserve the existing management's ability to influence important business decisions.

Calculate the financial break-even point of Bharat Renewables Ltd. considering its existing debt interest and preference dividend commitments.

1. ₹37 lakh
2. ₹40 lakh (correct answer)
3. ₹34 lakh
4. ₹46 lakh

Answer: B — ₹40 lakh

Explanation. Financial BEP = Interest + Preference dividend/(1 − Tax rate). Annual interest = ₹200 lakh × 14% = ₹28 lakh. Annual preference dividend = ₹60 lakh × 15% = ₹9 lakh. Financial BEP = ₹28 lakh + ₹9 lakh/0.75 = ₹28 lakh + ₹12 lakh = ₹40 lakh. Thus, the company requires EBIT of ₹40 lakh to meet all fixed financial charges and leave zero earnings for ordinary shareholders. Preference dividend must be grossed up because it is paid after tax.

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

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

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

Using the cash flow available for debt servicing, calculate Bharat Renewables Ltd.'s Debt Service Coverage Ratio (DSCR). Assume debt service comprises annual interest and scheduled principal repayment.

1. 1.25 times
2. 2.00 times
3. 1.50 times
4. 1.67 times (correct answer)

Answer: D — 1.67 times

Explanation. DSCR = Cash flow available for debt servicing/Total debt service. Annual interest = ₹200 lakh × 14% = ₹28 lakh. Scheduled principal repayment = ₹32 lakh. Total debt service = ₹28 lakh + ₹32 lakh = ₹60 lakh. DSCR = ₹100 lakh/₹60 lakh = 1.6667 times, approximately 1.67 times. Therefore, the company generates ₹1.67 of available cash flow for every ₹1 of debt service. Using only interest in the denominator would overstate repayment capacity.

Where it goes wrong. Calculating debt-servicing capacity using interest alone and ignoring scheduled repayment of principal.

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

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

Calculate the percentage shareholding of the promoters after the proposed issue of 6 lakh new equity shares. What does this indicate about the control implications of the equity financing alternative?

1. 40%; promoter majority is lost, making debt financing preferable from the control perspective. (correct answer)
2. 60%; promoter majority remains unchanged.
3. 50%; promoters retain majority control.
4. 45%; promoter majority is retained.

Answer: A — 40%; promoter majority is lost, making debt financing preferable from the control perspective.

Explanation. Existing total shares = 12 lakh. Promoter holding = 7.20 lakh shares. New outside equity issue = 6 lakh shares. Total post-issue shares = 12 lakh + 6 lakh = 18 lakh. Promoters' revised holding = 7.20/18 × 100 = 40%. Consequently, promoters lose their majority ownership. Debt financing would not dilute existing ownership, although it would increase financial risk through additional fixed interest commitments.

Where it goes wrong. Calculating promoters' ownership using the original number of shares rather than the enlarged post-issue equity share capital.

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

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

Bharat Renewables Ltd. proposes to refinance its ₹200 lakh existing debt carrying interest at 14% with new debt carrying interest at 11%. Calculate the annual interest saving before tax and identify the capital structure principle illustrated by the transaction.

1. ₹4 lakh; Risk Principle
2. ₹8 lakh; Control Principle
3. ₹6 lakh; Flexibility Principle (correct answer)
4. ₹3 lakh; Cost Principle only

Answer: C — ₹6 lakh; Flexibility Principle

Explanation. Existing annual interest = ₹200 lakh × 14% = ₹28 lakh. Revised annual interest = ₹200 lakh × 11% = ₹22 lakh. Annual interest saving = ₹28 lakh − ₹22 lakh = ₹6 lakh. The transaction illustrates the Flexibility Principle because debt can be refinanced or replaced when cheaper financing becomes available. Unlike equity investment, existing debt can often be interchanged with new debt, subject to contractual and market conditions.

Where it goes wrong. Applying the new interest rate to the difference between the two interest rates rather than to the outstanding principal.

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

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

Scenario. Aditya Industrial Components Ltd. operates two manufacturing divisions following a recent corporate restructuring. The first division manufactures conventional automobile components and was acquired through a substantial issue of equity and debt. The second division manufactures specialised electric-vehicle components and has consistently earned returns above the industry average. The finance committee has identified possible over-capitalisation in the acquired division and under-capitalisation in the electric-vehicle division. Financial information: Particulars | Acquired Division | EV Components Division Actual capitalisation | ₹500 lakh | ₹480 lakh Annual maintainable earnings | ₹40 lakh | ₹72 lakh Normal industry rate of return | 10% | 12% Further information: Corporate EBIT | ₹96 lakh Existing long-term debt | ₹200 lakh Interest rate on debt | 12% Corporate tax rate | 30% Equity beta | 1.40 Risk-free rate | 6% Expected market risk premium | 5% Annual operating cash flow after tax, before financing | ₹110 lakh EV division equity shares outstanding | 10 lakh shares The acquired division's capitalisation includes ₹80 lakh attributable to goodwill acquired at a substantial premium. Management also discovered that historical depreciation provisions were inadequate and that part of the funds raised through earlier issues of securities remained unutilised. These circumstances have contributed to the division's weak earnings relative to its capital base. The EV Components Division has 10 lakh equity shares and distributes dividends based on its annual earnings. Management is considering a one-for-four bonus issue to adjust its unusually high per-share earnings and improve the marketability of its shares. Assume that the bonus issue will not affect aggregate earnings. Working-capital information: Raw-material holding period: 30 days Work-in-process period: 15 days Finished-goods holding period: 25 days Receivables collection period: 65 days Trade-credit period: 35 days The board requires a financial assessment of the two divisions, identification of suitable corrective measures and an appropriate capital structure that considers profitability, financial risk and shareholder interests.

Determine the amount of over-capitalisation in the acquired division of Aditya Industrial Components Ltd. using the normal industry return as the appropriate capitalisation rate.

1. ₹80 lakh
2. ₹100 lakh (correct answer)
3. ₹120 lakh
4. ₹160 lakh

Answer: B — ₹100 lakh

Explanation. Proper capitalisation = Maintainable annual earnings/Normal rate of return. Proper capitalisation = ₹40 lakh/10% = ₹400 lakh. Actual capitalisation = ₹500 lakh. Therefore, over-capitalisation = ₹500 lakh − ₹400 lakh = ₹100 lakh. The acquired division has raised or retained more capital than its earning capacity justifies. The actual return on capital is only ₹40 lakh/₹500 lakh × 100 = 8%, against the normal 10% return.

Where it goes wrong. Calculating over-capitalisation by applying the normal return to actual capital rather than using the earnings to calculate proper capitalisation.

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

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

Calculate the amount of under-capitalisation in the EV Components Division of Aditya Industrial Components Ltd.

1. ₹90 lakh
2. ₹100 lakh
3. ₹120 lakh (correct answer)
4. ₹150 lakh

Answer: C — ₹120 lakh

Explanation. Proper capitalisation = Maintainable earnings/Normal rate of return = ₹72 lakh/12% = ₹600 lakh. Actual capitalisation = ₹480 lakh. Under-capitalisation = Proper capitalisation − Actual capitalisation = ₹600 lakh − ₹480 lakh = ₹120 lakh. The division's actual capitalisation is lower than the amount justified by its earning capacity. Its actual return is ₹72 lakh/₹480 lakh × 100 = 15%, which exceeds the normal industry return of 12%.

Where it goes wrong. Reversing the formula and treating actual capitalisation as the proper capitalisation despite the higher earning capacity.

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

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

The acquired division is facing declining earnings, insufficient dividend-paying capacity and a falling market price of its shares. Which corrective action is most appropriate for the identified over-capitalisation?

1. Issue bonus shares to increase the number of outstanding shares.
2. Increase the face value of shares without changing the capital structure.
3. Raise additional equity to meet future operating expenses.
4. Undertake financial reorganisation and consider buyback of shares or reduction in claims of debenture-holders and creditors. (correct answer)

Answer: D — Undertake financial reorganisation and consider buyback of shares or reduction in claims of debenture-holders and creditors.

Explanation. Over-capitalisation arises when a company has more capital than it can employ profitably. Appropriate remedies include thorough reorganisation, buyback of shares, reduction in claims of debenture-holders and creditors, and reduction in the value of shares where appropriate. These measures seek to align the capital structure with the company's actual earning capacity. A bonus issue is more appropriate as a remedy for under-capitalisation, not over-capitalisation.

Where it goes wrong. Confusing the corrective measures for under-capitalisation with those required to address over-capitalisation.

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

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

The EV Components Division has 10 lakh equity shares and annual maintainable earnings of ₹72 lakh. It proposes a one-for-four bonus issue. Calculate the revised EPS after the bonus issue, assuming aggregate earnings remain unchanged.

1. ₹5.76 (correct answer)
2. ₹6.40
3. ₹7.20
4. ₹4.80

Answer: A — ₹5.76

Explanation. Existing EPS = ₹72 lakh/10 lakh shares = ₹7.20. Under a one-for-four bonus issue, new shares = 10 lakh × 1/4 = 2.50 lakh. Revised total shares = 10 lakh + 2.50 lakh = 12.50 lakh. Revised EPS = ₹72 lakh/12.50 lakh = ₹5.76. The reduction is 20%, while aggregate earnings remain ₹72 lakh. A bonus issue is an appropriate remedy for under-capitalisation because it reduces EPS and the dividend per share relative to the enlarged share base.

Where it goes wrong. Adding bonus shares to the existing shares but also incorrectly increasing aggregate earnings or treating the bonus issue as a cash-funded equity issue.

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

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

Scenario. A manufacturing company has annual interest of ₹18 lakh, preference dividend of ₹9 lakh and a corporate tax rate of 25%. Calculate its financial break-even EBIT.

A manufacturing company has annual interest of ₹18 lakh, preference dividend of ₹9 lakh and a corporate tax rate of 25%. Calculate its financial break-even EBIT.

1. ₹27 lakh
2. ₹30 lakh (correct answer)
3. ₹36 lakh
4. ₹24 lakh

Answer: B — ₹30 lakh

Explanation. Financial break-even EBIT = Interest + Preference dividend/(1 − Tax rate). Substituting: ₹18 lakh + ₹9 lakh/(1 − 0.25) = ₹18 lakh + ₹9 lakh/0.75 = ₹18 lakh + ₹12 lakh = ₹30 lakh. At this level of EBIT, all fixed financing charges are met and earnings available to ordinary shareholders are zero. The preference dividend is grossed up because it is not deductible while computing taxable profits.

Where it goes wrong. Using ₹27 lakh as the break-even point by adding interest and preference dividend without the tax adjustment.

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

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

Scenario. A company has a financial break-even point of ₹54 lakh. Its annual interest commitment is ₹30 lakh and the corporate tax rate is 20%. Determine the annual preference dividend commitment.

A company has a financial break-even point of ₹54 lakh. Its annual interest commitment is ₹30 lakh and the corporate tax rate is 20%. Determine the annual preference dividend commitment.

1. ₹30 lakh
2. ₹24 lakh
3. ₹19.80 lakh
4. ₹19.20 lakh (correct answer)

Answer: D — ₹19.20 lakh

Explanation. Financial BEP = Interest + PD/(1 − t). Substituting: ₹54 lakh = ₹30 lakh + PD/0.80. Therefore, PD/0.80 = ₹24 lakh. Annual preference dividend = ₹24 lakh × 0.80 = ₹19.20 lakh. The dividend must be derived using the after-tax balance because preference dividends are paid out of post-tax earnings. Using ₹24 lakh directly as the dividend would ignore the tax gross-up.

Where it goes wrong. Treating the excess of financial BEP over interest as the preference dividend without multiplying it by (1 − tax rate).

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

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

Scenario. A company has two outstanding debenture issues: ₹120 lakh carrying interest at 10% and ₹80 lakh carrying interest at 12%. It also has preference share capital of ₹15 lakh carrying a 20% dividend. If the corporate tax rate is 25%, calculate the financial break-even EBIT.

A company has two outstanding debenture issues: ₹120 lakh carrying interest at 10% and ₹80 lakh carrying interest at 12%. It also has preference share capital of ₹15 lakh carrying a 20% dividend. If the corporate tax rate is 25%, calculate the financial break-even EBIT.

1. ₹24.60 lakh
2. ₹28.60 lakh
3. ₹25.60 lakh (correct answer)
4. ₹31.60 lakh

Answer: C — ₹25.60 lakh

Explanation. Interest on first issue = ₹120 lakh × 10% = ₹12 lakh. Interest on second issue = ₹80 lakh × 12% = ₹9.60 lakh. Total interest = ₹21.60 lakh. Preference dividend = ₹15 lakh × 20% = ₹3 lakh. Financial BEP = ₹21.60 lakh + ₹3 lakh/0.75 = ₹21.60 lakh + ₹4 lakh = ₹25.60 lakh. All debt interest is deducted before tax, while preference dividend is grossed up.

Where it goes wrong. Applying the tax gross-up to interest as well as preference dividend, or omitting one of the debt issues while calculating annual interest.

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 total capital employed of ₹600 lakh and generates annual EBIT of ₹90 lakh. The proposed debt financing carries an interest rate of 10%. Determine the return on capital employed and the implication for financial leverage, assuming other factors remain unchanged.

A company has total capital employed of ₹600 lakh and generates annual EBIT of ₹90 lakh. The proposed debt financing carries an interest rate of 10%. Determine the return on capital employed and the implication for financial leverage, assuming other factors remain unchanged.

1. 15%; favourable financial leverage because operating return exceeds the debt interest rate by 5 percentage points. (correct answer)
2. 10%; unfavourable leverage because the operating return equals the debt interest rate.
3. 12%; favourable leverage because operating return exceeds the debt interest rate by 2 percentage points.
4. 15%; unfavourable leverage because the operating return exceeds the debt interest rate.

Answer: A — 15%; favourable financial leverage because operating return exceeds the debt interest rate by 5 percentage points.

Explanation. Return on capital employed = EBIT/Capital employed × 100 = ₹90 lakh/₹600 lakh × 100 = 15%. Cost of debt = 10%. Excess operating return = 15% − 10% = 5 percentage points. Since the rate of return on capital employed exceeds the cost of debt, additional debt can increase earnings attributable to equity shareholders, subject to the associated financial risk. If operating return fell below the borrowing cost, the leverage effect could become adverse.

Where it goes wrong. Comparing net profit after interest with the borrowing rate instead of comparing the operating return before interest with the cost of debt.

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

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

Scenario. A company generates cash flow available for debt servicing of ₹144 lakh annually. Its annual interest commitment is ₹24 lakh. A lender requires a minimum DSCR of 1.50 times. Calculate the maximum annual principal repayment that the company can undertake while satisfying this condition.

A company generates cash flow available for debt servicing of ₹144 lakh annually. Its annual interest commitment is ₹24 lakh. A lender requires a minimum DSCR of 1.50 times. Calculate the maximum annual principal repayment that the company can undertake while satisfying this condition.

1. ₹60 lakh
2. ₹72 lakh (correct answer)
3. ₹96 lakh
4. ₹84 lakh

Answer: B — ₹72 lakh

Explanation. Minimum DSCR = Cash flow available for debt servicing/Total debt service. Therefore, maximum permissible total debt service = ₹144 lakh/1.50 = ₹96 lakh. Annual interest = ₹24 lakh. Maximum principal repayment = ₹96 lakh − ₹24 lakh = ₹72 lakh. Thus, the company can service principal of up to ₹72 lakh annually while maintaining the lender's stipulated coverage ratio. Using the full ₹96 lakh as principal would incorrectly ignore interest.

Where it goes wrong. Treating the maximum permissible total debt service as the maximum principal repayment without deducting annual interest.

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

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

Scenario. The promoters of a company hold 64% of its existing 15 lakh equity shares. The company proposes to issue 3.60 lakh additional equity shares to outside investors. Calculate the revised promoter shareholding percentage and determine whether majority control is preserved.

The promoters of a company hold 64% of its existing 15 lakh equity shares. The company proposes to issue 3.60 lakh additional equity shares to outside investors. Calculate the revised promoter shareholding percentage and determine whether majority control is preserved.

1. 48.00%; majority control is lost.
2. 50.00%; majority control is preserved.
3. 51.61%; majority control is preserved. (correct answer)
4. 55.00%; majority control is preserved.

Answer: C — 51.61%; majority control is preserved.

Explanation. Promoter shares = 15 lakh × 64% = 9.60 lakh shares. Total shares after issue = 15 lakh + 3.60 lakh = 18.60 lakh shares. Revised promoter ownership = 9.60/18.60 × 100 = 51.6129%, approximately 51.61%. As the percentage remains above 50%, the promoters retain majority control. The new issue dilutes their existing percentage but does not eliminate majority ownership.

Where it goes wrong. Calculating the promoter percentage against existing shares only instead of total post-issue shares.

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

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

Scenario. A credit rating agency requires that a company's debt-equity ratio must not exceed 0.80:1. Its existing market value of equity is ₹250 lakh and existing debt is ₹160 lakh. Calculate the maximum additional debt that can be raised without breaching this requirement.

A credit rating agency requires that a company's debt-equity ratio must not exceed 0.80:1. Its existing market value of equity is ₹250 lakh and existing debt is ₹160 lakh. Calculate the maximum additional debt that can be raised without breaching this requirement.

1. ₹30 lakh
2. ₹35 lakh
3. ₹50 lakh
4. ₹40 lakh (correct answer)

Answer: D — ₹40 lakh

Explanation. Maximum permissible debt = Equity × Maximum debt-equity ratio = ₹250 lakh × 0.80 = ₹200 lakh. Existing debt = ₹160 lakh. Therefore, additional borrowing capacity = ₹200 lakh − ₹160 lakh = ₹40 lakh. The agency's condition is based on debt relative to equity, not debt as a proportion of total capital. Raising ₹50 lakh would increase debt to ₹210 lakh, creating a ratio of 0.84:1 and breaching the requirement.

Where it goes wrong. Applying the stipulated debt-equity ratio to total capital instead of equity, or confusing debt-to-equity with debt-to-total-capital.

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

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

Scenario. A company proposes to finance a new ₹200 lakh investment by borrowing at an annual interest rate of 13%. The investment is expected to generate an EBIT return of 11% on the amount invested. Calculate the annual adverse financing spread and identify the correct financing implication.

A company proposes to finance a new ₹200 lakh investment by borrowing at an annual interest rate of 13%. The investment is expected to generate an EBIT return of 11% on the amount invested. Calculate the annual adverse financing spread and identify the correct financing implication.

1. ₹4 lakh adverse spread; debt financing is unfavourable because the return on investment is below the cost of debt. (correct answer)
2. ₹4 lakh favourable spread; debt financing increases EPS.
3. ₹26 lakh favourable spread; debt financing should be preferred.
4. ₹22 lakh adverse spread; equity financing is necessarily more expensive.

Answer: A — ₹4 lakh adverse spread; debt financing is unfavourable because the return on investment is below the cost of debt.

Explanation. Expected annual EBIT from the investment = ₹200 lakh × 11% = ₹22 lakh. Annual interest = ₹200 lakh × 13% = ₹26 lakh. Adverse financing spread = ₹26 lakh − ₹22 lakh = ₹4 lakh. Since the return generated by the investment is lower than the borrowing cost, debt financing would have an adverse leverage effect on equity earnings, before considering other effects. Equity financing may therefore be more appropriate from the risk-return perspective.

Where it goes wrong. Assuming debt financing is automatically favourable because interest is tax-deductible, without checking whether the operating return exceeds its financing cost.

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 actual capitalisation of ₹600 lakh and annual maintainable earnings of ₹48 lakh. The normal industry rate of return is 12%. Calculate the over-capitalisation amount and the actual rate of return.

A company has actual capitalisation of ₹600 lakh and annual maintainable earnings of ₹48 lakh. The normal industry rate of return is 12%. Calculate the over-capitalisation amount and the actual rate of return.

1. ₹100 lakh; 10%
2. ₹200 lakh; 8% (correct answer)
3. ₹240 lakh; 12%
4. ₹150 lakh; 9%

Answer: B — ₹200 lakh; 8%

Explanation. Proper capitalisation = Maintainable earnings/Normal rate of return = ₹48 lakh/12% = ₹400 lakh. Actual capitalisation is ₹600 lakh. Over-capitalisation = ₹600 lakh − ₹400 lakh = ₹200 lakh. Actual return = ₹48 lakh/₹600 lakh × 100 = 8%. The company earns only 8% compared with the normal industry return of 12%, demonstrating that its capital base exceeds the amount justified by its earning capacity.

Where it goes wrong. Calculating the excess capital using the actual rate of return instead of the normal rate required to determine proper capitalisation.

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

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

Scenario. A company has actual capitalisation of ₹360 lakh and annual maintainable earnings of ₹54 lakh. The normal rate of return is 12%. It has 10 lakh equity shares and proposes a one-for-four bonus issue. Calculate the amount of under-capitalisation and the revised EPS after the bonus issue.

A company has actual capitalisation of ₹360 lakh and annual maintainable earnings of ₹54 lakh. The normal rate of return is 12%. It has 10 lakh equity shares and proposes a one-for-four bonus issue. Calculate the amount of under-capitalisation and the revised EPS after the bonus issue.

1. ₹90 lakh; ₹5.40
2. ₹120 lakh; ₹4.80
3. ₹100 lakh; ₹4.50
4. ₹90 lakh; ₹4.32 (correct answer)

Answer: D — ₹90 lakh; ₹4.32

Explanation. Proper capitalisation = ₹54 lakh/12% = ₹450 lakh. Under-capitalisation = ₹450 lakh − ₹360 lakh = ₹90 lakh. Existing EPS = ₹54 lakh/10 lakh = ₹5.40. Bonus shares = 10 lakh × 1/4 = 2.50 lakh. Revised shares = 12.50 lakh. Revised EPS = ₹54 lakh/12.50 lakh = ₹4.32. Aggregate earnings remain unchanged, and the bonus issue reduces the unusually high EPS by 20%.

Where it goes wrong. Calculating bonus shares as one-fourth of the enlarged share capital instead of one-fourth of the existing shares, or failing to calculate the proper capitalisation.

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

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

Scenario. A company raises ₹80 lakh through borrowings carrying interest at 15%. The funds are employed in assets that are expected to generate an annual operating return of 9%. Calculate the annual adverse financing spread and identify the relevant cause of over-capitalisation.

A company raises ₹80 lakh through borrowings carrying interest at 15%. The funds are employed in assets that are expected to generate an annual operating return of 9%. Calculate the annual adverse financing spread and identify the relevant cause of over-capitalisation.

1. ₹3.20 lakh; inadequate depreciation provisions.
2. ₹6.00 lakh; excessive acquisition of fictitious assets.
3. ₹4.80 lakh; borrowing at a rate higher than the return generated by the company. (correct answer)
4. ₹12.00 lakh; excessive distribution of dividends.

Answer: C — ₹4.80 lakh; borrowing at a rate higher than the return generated by the company.

Explanation. Annual borrowing interest = ₹80 lakh × 15% = ₹12 lakh. Annual operating return generated by the assets = ₹80 lakh × 9% = ₹7.20 lakh. Adverse spread = ₹12 lakh − ₹7.20 lakh = ₹4.80 lakh. The company incurs financing costs higher than the earnings generated by the assets financed. This is a recognised cause of over-capitalisation because borrowing is undertaken at a rate exceeding the rate at which the funds can be profitably employed.

Where it goes wrong. Calculating the difference between the two percentage rates without multiplying the spread by the amount borrowed, or confusing the cause with an entirely different over-capitalisation factor.

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

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

Scenario. A company is evaluating two financing alternatives for a ₹100 lakh expansion. Under the equity plan, no additional interest is incurred. Under the debt plan, ₹20 lakh is raised through 15% debentures and the remaining amount through equity. Existing annual interest is ₹20 lakh and annual preference dividend is ₹6 lakh. The corporate tax rate is 25%. Management expects EBIT to fall to ₹35 lakh under adverse operating conditions. Calculate the financial break-even points and identify the more conservative financing alternative.

A company is evaluating two financing alternatives for a ₹100 lakh expansion. Under the equity plan, no additional interest is incurred. Under the debt plan, ₹20 lakh is raised through 15% debentures and the remaining amount through equity. Existing annual interest is ₹20 lakh and annual preference dividend is ₹6 lakh. The corporate tax rate is 25%. Management expects EBIT to fall to ₹35 lakh under adverse operating conditions. Calculate the financial break-even points and identify the more conservative financing alternative.

1. Equity plan BEP ₹28 lakh; debt plan BEP ₹31 lakh; equity plan provides a ₹7 lakh EBIT cushion and is more conservative. (correct answer)
2. Equity plan BEP ₹26 lakh; debt plan BEP ₹29 lakh; debt plan provides a higher EBIT cushion.
3. Equity plan BEP ₹31 lakh; debt plan BEP ₹28 lakh; equity financing is less conservative.
4. Equity plan BEP ₹20 lakh; debt plan BEP ₹23 lakh; both plans provide identical financial risk.

Answer: A — Equity plan BEP ₹28 lakh; debt plan BEP ₹31 lakh; equity plan provides a ₹7 lakh EBIT cushion and is more conservative.

Explanation. Equity plan: BEP = Existing interest ₹20 lakh + ₹6 lakh/0.75 = ₹28 lakh. Debt plan: Additional interest = ₹20 lakh × 15% = ₹3 lakh. Total interest = ₹23 lakh. BEP = ₹23 lakh + ₹6 lakh/0.75 = ₹31 lakh. At downside EBIT of ₹35 lakh, the equity plan has a cushion of ₹35 lakh − ₹28 lakh = ₹7 lakh, while the debt plan has only ₹4 lakh. Equity financing therefore provides the greater safety margin.

Where it goes wrong. Ignoring existing fixed financial commitments or failing to include additional debenture interest when determining the revised financial break-even point.

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