Vastupal Limited is currently a levered a company having 15% convertible debt of 250 lakhs in its capital structure. The current market value of…

CA Intermediate · Financial Management and Strategic Management · MTP · January 2026
Vastupal Limited is currently a levered a company having 15% convertible debt of 250 lakhs in its capital structure. The current market value of Vastupal Limited stands at 1500 lakhs with the overall capitalization rate for the common stock holders is at 20% considering financial and non-financial risks. Owing to the regulatory norms applicable to Vastupal Limited, the company is planning to become an all equity financed company gradually over a period of time. Currently, company plans to convert 70% of debt to equity and the balance after 3 years. It's Earnings before Interest & Taxes (EBIT) are expected to remain constant in future as well. The entire earnings are distributed to the common stock holders and the applicable corporate tax rate is at 20%. You are required to calculate the impact on the following on account of the change in the capital structure as per Modigliani and Miller (MM) Hypothesis: (i) The market value of the company and its impact (ii) It's cost of equity, and its impact (iii) It's cost of capital and its impact Also CALCULATE the market value of the totally unlevered company & the cost of equity i.e. after 3 years when the balance 30% convertible debt is also fully converted to equity.

Suggested Answer and Working Notes:

(i) Market Value of Vastupal Limited (After conversion) Value of Levered Co (V L ) = Value of Substantial Unlevered Co (V U ) + Tax advantage 1,500 lakhs = V U + (250 x 70% x 20%) ∴ Market Value of Substantial Unlevered Co (V U ) = 1,465 Lakhs Alternatively, Market Value of Substantial Unlevered Co (V U ) can be calculated as below: MV of Substantial Unlevered Co (30% Debt) = MV of Totally Unlevered Co + Tax advantage = {1500-0.20(250)} + (250 x 30% x 20%) = 1,450 + 15 Market Value of Substantial Unlevered Co (V U ) = 1,465 Lakhs The impact is that the market value of the company has decreased by 35 lakhs (1500 lakhs - 1465 lakhs) (ii) Cost of Equity (K e ) – After conversion WN-1 Preparation of Income Statement Particulars Before Conversion After Conversion EBIT 350.00 350.00 (-) Int (37.50) (11.25) (250 x 15%) (250 x 30% x 15%) EBT 312.50 338.75 (-) Tax @ 20% (62.50) (67.75) Dividend 250.00 271.00 MV of Equity (Before conversion) = Dividend / K e (1,500 – 250) = Dividend / 0.2 ∴ Dividend = 250 Lakhs MV of Equity (After Conversion) = MV of Co (After conversion) - MV of Remaining Debt = 1,465 - {250 x 30%} = 1,390 lakhs ∴ K e (after Conversion) = Dividend / MV of Equity = 271 / 1,390 = 19.49% The impact is that cost of equity has fallen by 0.50% i.e. 20.00% - 19.49% due to reduction in the financial risk. (iii) Cost of Capital (K o ) – After Conversion Components Amount (in lakhs) Weights (W) Cost of Capital (K) WACC (W x K) Equity 1390.00 0.9488 19.49 18.49 Debt 75.00 0.0512 12.00 0.61 15 (1 – 0.2) 1465.00 19.10% Cost of Capital (K o ) – Before Conversion Components Amount (in lakhs) Weights (W) Cost of Capital (K) WACC (W x K) Equity 1250.00 0.8333 20.00 16.67 Debt 250.00 0.1667 12.00 2.00 15 (1 – 0.2) 1500.00 18.67% The impact is that the overall cost of capital has increased by 0.43% i.e. 19.10% - 18.67% due to non-availability of tax benefit owing to the reduction in the debt. WN-2: Calculation of Market Value of the company & K e after the end of 3 years MV of Substantial Unlevered Co = MV of Totally Unlevered Co + Tax advantage 1,465 lakhs = MV of Totally Unlevered Co + (250 x 30% x 20%) ∴ MV of Totally Unlevered Co = 1,450 lakhs Calculation of K e of Totally Unlevered Co K e = Dividend / MV of Equity Particulars Amount EBIT 350.00 (-) Int 0.00 EBT 350.00 (-) Tax @20% (70.00) Dividend 280.00 ∴ K e = 280/1,450 ∴ K e = 19.31%

Topics: Part-A: Financial Management

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