2009

Case Analysis:
SoftDrink Company
Capital Structure Decision

Submitted By

Sec A (Seat No. 61-66)

Manish Mittal 09BSHYD0427
Kirti 09BSHYD0384
Neha Gupta 09BSHYD0498
Ritika Choraria 09BSHYD0671
Surbhi Nagpal 09BSHYD0890

Submitted To

Dr. Vunyale Narender

IBS
Hyderabad
12/7/2009
Case analysis
The case analysis has been done in following steps:
 Calculation of expected sales using the projected sales figures and associated
probabilities
SALES PROBABILITY EXPECTED SALES
400000 0.25 100000
600000 0.5 300000
800000 0.25 200000
TOTAL 600000
Table 1.1
 Calculation of EBIT

EXPECTED SALES 600000

LESS VARIABLE
300000
COST@50%
CONTRIBUTION 300000
LESS FIXED COST 200000
EBIT 100000
Table 1.2
 Calculation of proportion of debt in the capital structure as per various
options available with the Company
TOTAL CAPITAL=RS 500000
DEBT% DEBT AMOUNT COST OF DEBT
0 0 0.000
10 50000 0.090
20 100000 0.095
30 150000 0.100
40 200000 0.110
50 250000 0.135
60 300000 0.165
Table 1.3
  Evaluation of various options available to the company
PARTICULARS 1 2 3 4 5 6 7
PROPORTION OF DEBT 0% 10% 20% 30% 40% 50% 60%
AMOUNT OF DEBT 0 50000 100000 150000 200000 250000 300000

EBIT 100000 100000 100000 100000 100000 100000 100000

LESS INTEREST 0 4500 9500 15000 22000 33750 49500

EBT 100000 95500 90500 85000 78000 66250 50500

NO OF EQUITY SHARES 25000 22500 20000 17500 15000 12500 10000

DPS 4.00 4.24 4.53 4.86 5.20 5.30 5.05

COST OF EQUITY(Ke) 0.20 0.21 0.23 0.24 0.26 0.27 0.25

COST OF DEBT(Kd) 0.000 0.090 0.095 0.100 0.110 0.135 0.165

VALUE OF EQUITY(E) 500000 450000 400000 350000 300000 250000 200000

VALUE OF DEBT(D) 0 50000 100000 150000 200000 250000 300000
VALUE OF FIRM(V) 500000 500000 500000 500000 500000 500000 500000
Ko(WACC) 0.2000 0.2000 0.2000 0.2000 0.2000 0.2000 0.2000
Table 1.4
Working Notes

GIVEN THAT
SHARE VALUE P0= 20
NOW,
P0=DIV/ke
THUS Ke=DIV/P0
Where P0=
Price in period
zero
DPS= (EBIT-INT)/No. of Shares
Also,
Ko (WACC) =[ Ke * {E/(E+D)}] + [ Kd * {D/(E+D)}]
The dividend payout ratio is 100% ,therefore, EPS=DPS

Value of equity is the capitalized value of net earnings i.e. net income
Value of Equity(E) = (EBIT- Interest)/Ke
Value of Debt(D) = (Interest)/Kd
Value of Firm(V) = E+D

Findings
As we can see from the Table1.4 that the value of the firm and the WACC for
the company remains the same under various Capital Structure options
available to the Company.
Thus we can infer that the value of the Firm is not affected by the capital
structure decision.

0.30

0.25

0.20
Ke
Kd ,Ke,Ko 0.15
Kd
0.10 Ko

0.05

0.00
1 2 3 4 5 6 7
Options
From the graph we can see that Ko is constant and Ke is increasing at a decreasing
rate and eventually falling after extremely leveraged situation i.e. after Option 6.
The cost of debt is constantly increasing because the risk perception of the debt
holders increases with increased leverage.

Relevance : Modigliani and Miller (MM) Hypothesis Proposition II

The MM model provides the behavioral justification of the Net Operating Income
approach (NOI Approach) and explains the irrelevance of capital budgeting
decision on the value of the firm as is evident from table 1.4 above.
According to Proposition II the levered firm’s opportunity cost of capital will not
rise even if very excessive use of financial leverage is made. The excessive use of
debt increases the risk of default. Hence, in practice, the cost of debt, Kd, will
increase with high level of financial leverage. MM argued that when Kd increases,
Ke will increase at a decreasing rate and may even turn down eventually. The
reason for this behavior of Ke , is that debt holders, in the extreme leveraged
situation own the firm’s assets and bear some of the firm’s business risk. Since the
operating risk of shareholders is transferred to debt holders, Ke declines.
Now, our situation is matching with that of MM because our cost of debt is
increasing with financial leverage and Ke is also increasing but at a decreasing rate
and eventually turns down after Option No.6 because of extremely leveraged
situation (60% Debt Employment).
Answers:
Q1 As a finance manager, using the data, decide upon a choice of the capital
structure that you would advise the firm.
Ans. The capital structure of equal proportion of debt and equity is advisable to the
firm.
Q2. The reasons for the usage of specific proportion of debt i.e. Leverage
Ans. The dividend per share (DPS) is increasing with increased leverage i.e.
increased use of debt, up to Option 6 i.e. 50% debt in the capital structure (from
Rs.4.00 per share to Rs. 5.30 per share) but after this point the DPS falls from
Rs.5.30 to Rs.5.05.If the goal of the management is to maximize the return to the
shareholders option 6 is optimum capital structure.
Q3. What can be best option for the firm?
Ans. The Option no. 6 having 50% debt in the capital structure should be used by
the firm.
Q4. Why your option is the best bet- reasons to substantiate the same?
Ans. According to Pecking Order Theory, in a capital structure decision the firm
usually follows the following order in raising the capital
1. Managers always prefer to use internal finance (Retained Earnings).
2. When they do not have internal finance, they prefer issuing debt. They first
issue secured debt and then unsecured debt followed by hybrid securities
such as convertible debentures.
3. As a last resort, managers issue shares to raise finances.
Since it is assumed that there are no retained earnings, the firm goes for debt
financing and keeps on increasing the proportion of debt, but up to a certain extent.
In our case when we increase the debt proportion to 60% the return to shareholders
i.e. Dividends decreases from Rs.5.30 to Rs.5.05
Moreover DPS is continuously increasing with increasing financial leverage.
Thus Option 6 with 50% debt is the best bet.