CA Inter P6 · Chapter 5

Financing Decisions – Capital Structure MCQs with Answers

9 multiple-choice questions on Financing Decisions – Capital Structure for CA Inter P6 Financial Management and Strategic Management. Try each one before revealing the answer and explanation.

1. Question 1

   Under the Net Income (NI) approach, a firm has EBIT of ₹ 6,00,000, 10% debt of ₹ 20,00,000 and a cost of equity of 15%. There are no taxes. The total value of the firm is:

   • A) ₹ 26,66,667
   • B) ₹ 40,00,000
   • C) ₹ 60,00,000
   • D) ₹ 46,66,667
   Show answer & explanation

   Answer: D) ₹ 46,66,667

   Net income to equity = EBIT - interest = ₹ 6,00,000 - ₹ 2,00,000 = ₹ 4,00,000. Value of equity S = ₹ 4,00,000 / 0.15 = ₹ 26,66,667. Value of firm V = S + D = ₹ 26,66,667 + ₹ 20,00,000 = ₹ 46,66,667. Overall cost of capital = ₹ 6,00,000 / ₹ 46,66,667 = 12.86%.

2. Question 2

   Under the Net Operating Income (NOI) approach, a firm has EBIT of ₹ 8,00,000 and an overall capitalisation rate of 12.5%. It has 9% debt of ₹ 24,00,000. Ignoring taxes, the implied cost of equity is:

   • A) 14.6%
   • B) 9.125%
   • C) 12.5%
   • D) 20.0%
   Show answer & explanation

   Answer: A) 14.6%

   Value of firm V = EBIT / Ko = ₹ 8,00,000 / 0.125 = ₹ 64,00,000. Value of equity = ₹ 64,00,000 - ₹ 24,00,000 = ₹ 40,00,000. Earnings for equity = ₹ 8,00,000 - ₹ 2,16,000 = ₹ 5,84,000. Ke = ₹ 5,84,000 / ₹ 40,00,000 = 14.6%. Under NOI, Ke rises with leverage while Ko stays constant at 12.5%.

3. Question 3

   According to Modigliani and Miller (with corporate taxes), an unlevered firm is valued at ₹ 50 crore. An otherwise identical firm has ₹ 20 crore of permanent debt, and the corporate tax rate is 30%. The value of the levered firm is:

   • A) ₹ 50 crore
   • B) ₹ 56 crore
   • C) ₹ 70 crore
   • D) ₹ 44 crore
   Show answer & explanation

   Answer: B) ₹ 56 crore

   With corporate taxes, MM state that VL = VU + tD, where tD is the present value of the interest tax shield on permanent debt. VL = 50 + 0.30 x 20 = 50 + 6 = ₹ 56 crore. ₹ 50 crore would be the result under MM without taxes. ₹ 70 crore wrongly adds the full debt.

4. Question 4

   Swastik Ltd needs ₹ 50 lakh for a new venture. Plan I: issue 5,00,000 equity shares of ₹ 10 each. Plan II: issue ₹ 20 lakh of 12% debentures and 3,00,000 equity shares of ₹ 10 each. The tax rate is 30%. The EBIT at which EPS is the same under both plans is:

   • A) ₹ 6,00,000
   • B) ₹ 8,57,143
   • C) ₹ 2,40,000
   • D) ₹ 4,80,000
   Show answer & explanation

   Answer: A) ₹ 6,00,000

   Interest under Plan II = 12% x 20,00,000 = ₹ 2,40,000. Set EPS equal: EBIT(1 - 0.3)/5,00,000 = (EBIT - 2,40,000)(1 - 0.3)/3,00,000. Then 3 EBIT = 5 EBIT - 12,00,000, so EBIT = ₹ 6,00,000. Check: EPS = 6,00,000 x 0.7 / 5,00,000 = ₹ 0.84 under Plan I, and 3,60,000 x 0.7 / 3,00,000 = ₹ 0.84 under Plan II.

5. Question 5

   According to the Traditional approach to capital structure:

   • A) The cost of equity stays constant while the cost of debt rises steeply from the first rupee of borrowing
   • B) Using debt sensibly lowers the overall cost of capital up to a point, beyond which Ko rises, so an optimum capital structure exists
   • C) The overall cost of capital stays constant whatever the debt-equity mix
   • D) The value of the firm keeps increasing as debt is increased up to 100%
   Show answer & explanation

   Answer: B) Using debt sensibly lowers the overall cost of capital up to a point, beyond which Ko rises, so an optimum capital structure exists

   The Traditional approach takes a middle path between NI and NOI. At moderate leverage, Ke rises only slowly and cheaper debt reduces Ko. Beyond a certain level, both Ke and Kd rise sharply and Ko increases. So there is an optimum capital structure where Ko is lowest. A constant Ko is the NOI and MM (no tax) view.

6. Question 6

   Under Modigliani-Miller Proposition II (no taxes), a firm has an overall cost of capital of 12%, a cost of debt of 8% and a debt-equity ratio of 0.5. Its cost of equity is:

   • A) 12%
   • B) 16%
   • C) 14%
   • D) 10%
   Show answer & explanation

   Answer: C) 14%

   MM Proposition II states that Ke = Ko + (Ko - Kd) x D/E = 12% + (12% - 8%) x 0.5 = 12% + 2% = 14%. The cost of equity rises in line with leverage to exactly offset the benefit of cheaper debt, so Ko stays at 12%.

7. Question 7

   According to the pecking order theory of capital structure, the order in which a firm prefers to raise funds is:

   • A) Debt first, then new equity, then internal accruals
   • B) Internal accruals first, then new equity, and debt as a last resort
   • C) New equity first, then debt, then internal accruals
   • D) Internal accruals first, then debt, and new equity issue as a last resort
   Show answer & explanation

   Answer: D) Internal accruals first, then debt, and new equity issue as a last resort

   Pecking order theory is based on information asymmetry. Managers prefer internal funds because they carry no issue costs and send no signal to the market. If external finance is needed, they prefer debt to equity, because a new equity issue may signal that management thinks the shares are overvalued.

8. Question 8

   Firms U and L are identical except that U is all-equity and L has ₹ 30 lakh of 8% debt. Both have EBIT of ₹ 10 lakh. U's equity is valued at ₹ 80 lakh. L's equity investors capitalise their earnings at 14%. There are no taxes. Under the MM arbitrage argument, which statement is correct?

   • A) L is valued at about ₹ 84,28,571 against an equilibrium value of ₹ 80,00,000, so it is overvalued and investors will sell L's shares, borrow personally and buy U's shares
   • B) Both firms are correctly valued at ₹ 80,00,000 and no arbitrage is possible
   • C) L's equilibrium value should be ₹ 1,10,00,000 because debt always adds its full amount to firm value
   • D) L is valued at about ₹ 84,28,571 and is undervalued, so investors will sell U's shares and buy L's shares
   Show answer & explanation

   Answer: A) L is valued at about ₹ 84,28,571 against an equilibrium value of ₹ 80,00,000, so it is overvalued and investors will sell L's shares, borrow personally and buy U's shares

   Value of L's equity = (10,00,000 - 2,40,000) / 0.14 = ₹ 54,28,571, so VL = ₹ 54,28,571 + 30,00,000 = ₹ 84,28,571. Under MM without taxes, VL should equal VU = ₹ 80,00,000. L is overvalued by about ₹ 4,28,571. Investors holding L's shares can sell them, borrow personally in the same proportion as L's debt and buy U's shares, earning the same income with less outlay, until the two values are equal.

9. Question 9

   Trade-off theory explains the optimal capital structure as the point where:

   • A) The dividend payout ratio is 100%
   • B) Cost of equity equals cost of debt
   • C) The firm has no debt at all
   • D) The marginal benefit of the interest tax shield equals the marginal expected cost of financial distress
   Show answer & explanation

   Answer: D) The marginal benefit of the interest tax shield equals the marginal expected cost of financial distress

   Trade-off theory accepts that debt adds value through the interest tax shield. As borrowing rises, so do the expected costs of financial distress and bankruptcy. The optimal level of debt balances the marginal tax benefit against these marginal costs.