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Answer of Question no.1.
Particulars
|
Per Unit
|
Total
|
Sales
Less: Variable Cost
|
20
15
|
4000000
3000000
|
Contribution
Less: Fixed Cost
|
5
|
1000000
300000
|
Earning Before Interest and Tax
(EBIT)
Less: Interest (500000 x 10%)
|
700000
50000
|
|
Earning Before Tax (EBT)
|
650000
|
a)
Degree
of Operating Leverage = Contribution / EBIT = 1000000 / 700000 = 1.429 : 1
b)
Degree
of Financial Leverage = EBIT / EBT = 700000 / 650000 = 1.077 : 1
c)
Degree
of Combined Leverage = Contribution / EBT = 1000000 / 650000 = 1.538
: 1
Answer of Question no. 2 (a).
Plz follow your
material. This method is clearly explained.
Answer of Question no. 2(b).
Given,
Rate of
Dividend (D) = 6.75 / 100 = 6.75%
Required rate
of return (r) = 9%
Face value of
Preference share (FV) = 100
Now,
Value of
preference shares = (D * FV) / r = (6.75 * 100) / 9 = Rs. 75
Answer of Question no. 4.
Net Income Approach (NI Approach):
The approach is
suggested by Durand. According to it, a firm can increase its value or lower
the overall cost of capital by increasing the proportion of debt in the capital
structure. In other words, if the degree of financial leverage increases, the
weighted average cost of capital would decline with every increase in the debt
content in total funds employed, while the value of the firm will increase.
Reverse would happen in a converse situation.
Chart 1 gives a graphical explanation of the theory.
Vertical axis measures cost and horizontal axis measures leverage, ie., debt /
Equity.
Chart:1
Net Income Theory
Leverage
(D/S)
It is based on
the following assumptions :
i) There are no
corporate taxes.
ii) The cost of
debt is less than cost of equity or equity capitalisation rate.
iii) The use of
debt content does not change the risk perception of investors as a result of
both the Kd (Debt capitalisation rate) and Ke (equity
capitalisation rate) remains constant.
The value of
the firm on the basis of Net Income Approach may be ascertained as follows :
V = S + D
Where,
V = Value of
the firm
S = Market
value of equity
D = Market
value of debt
And,
S = NI/Ke
Where,
S = Market
value of equity
NI = Earnings
available for equity shareholders
Ke =
Equity Capitalisation rate
Under, NI
approach, the value of a firm will be maximum at a point where weighted average
cost of capital is minimum. Thus, the theory suggests total or maximum possible
debt financing for minimising cost of capital.
Net Operating Income Approach (NOI) :
This approach
is also suggested by Durand, according to it, the market value of the firm is
not affected by the capital structure changes. The market value of the firm is
ascertained by capitalising the net operating income at the overall cost
of capital, which is constant.
In Chart 2 NOIT is represented.
The market
value of the firm is determined as :
V =
EBIT/Overall cost of capital
Where,
V = Market
value of the firm
EBIT = Earnings
before interest and tax
Overall cost of
capital = EBIT/Market Value of the firm
And,
S = V - D
Where,
S = Value of
equity
D = Market
value of debt
V = Market
value of firm
And,
Cost of equity
= EBIT/(V - D)
Where,
V = Market
value of the firm
EBIT = Earnings
before interest and tax
D = Market
value of debt
It is based on
the following assumptions :
i) The overall
cost of capital remains constant for all degree of debt equity mix.
ii) The market
capitalises value of the firm as a whole. Thus, the split between debt and
equity is not important.
iii) The use of
less costly debt funds increases the risk of shareholders. This causes the
equity capialisation rate to increase. Thus, the advantage of debt is set off
exactly by increase in equity capitalisation rate.
iv) There are
no corporate taxes.
v) The cost of
debt is constant.
Under, NOI
approach since overall cost of capital is constant, thus, there is no optimal
capital structure rather every capital structure is as good as any other and so
every capital structure is optimal.
Answer of Question no. 5(a).
Calculation of Net
Present Value (NPV):
Year
|
Cash flows (Lakhs)
|
Discounting factor
@ 18%
|
Present value of
Cash Inflow
|
1.
2.
3.
4.
5.
|
40,00,000
45,00,000
60,00,000
60,00,000
75,00,000
|
0.8475
0.7182
0.6086
0.5158
0.4371
|
33,90,000
32,31,900
36,51,600
30,94,800
32,78,250
|
A) Present Value of
Cash Inflow (Total) = 1,66,46,550
B) Less: Cost of
Investment = 2, 00,000
Net Present Value (A
– B) = 1,64,46,550
Answer of
Question no. 5(b).
Present value
of cash to be received after 3 years(V) = A / (1 + i)n
Here, A (Amount to be received after 3 years)
= 15,00,000
I (Rate of
interest ) = 0.0925
N (No of years)
= 3
V (Present
value) = ?
Now,
V = 15,00,000 /
(1.0925)3
V =
15,00,000 / 1.3040
V =
11,50,307
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