Net Income Approach

1. X Ltd. is expecting an annual EBIT of Rs. 1 lakh. The company has Rs. 4 lakhs in 10% debentures. The cost of equity capital or capitalisation rate is 12.5%. Calculate the total value of the firm and Overall Cost of Capital according to the Net Income Approach:
   Value of Firm = Rs. 8,80,000 ; Overall Cost of Capital = 11.36 %
2. (a) A company expects a net operating income of Rs. 80,000. It has Rs. 2,00,000, 8% Debentures. The equity capitalisation rate of the company is 10%. Calculate the value of the firm and overall capitalisation rate according to the Net Income Approach (ignoring income-tax).
   Value of Firm = Rs. 8,40,000 ; Overall Cost of Capital = 9.52 %
   (b) If the debenture debt is increased to Rs. 3,00,000, what shall be the value of the firm and the overall capitalisation rate?
   Value of Firm = Rs. 8,60,000 ; Overall Cost of Capital = 9.306 %

   Net Operating Income Approach

3. (a) A company expects a net operating income of Rs. 1,00,000. It has Rs. 5,00,000, 6% Debentures. The overall capitalisation rate is 10%.Calculate the value of the firm and the equity capitalisation rate (cost of equity) according to the Net Operating Income Approach.
   Value of Firm = Rs. 10,00,000 ; Equity Capitalization Rate = 14 %
   (b) If the debenture debt is increased to Rs. 7,50,000. what will be the effect on the value of the firm and the equity capitalisation rate?
   Value of Firm = Rs. 10,00,000 ; Equity Capitalization Rate = 22 %

   Traditional Approach

4. Compute the market value of the firm, value of Equity and the average cost of capital from the following information:
   Net Operating Income : Rs.2,00,000
   Total Investment = Rs. 10,00,000
   Equity Capitalization Rate :
   (a) If the firm uses no debt : 10%
   (b) If the firm uses Rs. 4,00,000 debenture : 11%
   (c) If the firm uses Rs. 6,00,000 debenture : 13 %
   Assume that Rs. 4,00,000 debentures can be raised at 5% rate of interest whereas Rs. 6,00,000 debentures can be raised at 6% rate of interest.
   (a) Value of Firm = Rs. 20,00,000 ; Value of Equity = Rs. 20,00,000 ; Average cost of Capital  = 10 %
   (b) Value of Firm = Rs. 20,36,636 ; Value of Equity = Rs. 16,36,363 ; Average cost of Capital  = 9.8 %
   (c) Value of Firm = Rs.18,61,538 ; Value of Equity =  Rs. 12,61,538 ; Average cost of Capital  = 10.7 %
   According to this theory, the value of the firm can be increased initially or the cost of capital can be decreased by using more debt as the debt is a cheaper source of funds than equity.Thus, optimum capital structure can be reached by a proper debt-equity mix. Beyond a particular point, the cost of equity increases because increased debt increases the financial risk of the equity shareholders. The advantage of cheaper debt at this point of capital structure is offset by increased cost of equity. After this there comes a stage, when the increased cost of equity cannot be offset by the advantage of low-cost debt.

   MM Approach

5. There are two firms ‘A’ and ‘B’ which are exactly identical except that A does not useany debt in its financing, while B has Rs. 2,50,000 , 6% Debentures in its financing. Boththe firms have earnings before interest and tax of Rs. 75,000 and the equity capitalization rate is 10%. Assuming the corporation tax is 50%, calculate the value of the firm.Solution
   The market value of firm A which does not use any debt.
   Vu = $\frac{\mathbf{EBIT}}{K}$= Rs. 7,50,000
   The market value of firm B which uses debt financing of Rs. 2,50,000
   Vt= Vu + t
   Vu = 7,50,000, t = 50% of Rs. 2,50,000
   = 7,50,000 + 1,25,000
   = Rs. 8,75,000