Page 137 - DMGT405_FINANCIAL%20MANAGEMENT

Unit 7: Capital Structure Decision

the now increasing makes the Ko increase. Therefore, the use of leverage beyond a point will Notes
have the effect of increase the overall cost of capital of the firm and thus results in the decrease
in the value of the firm.
Thus, there is a level of financial leverage in any firm, up to which it favorably affect the value
of the firm may decrease. There may be a particular leverage or a range of leverage, which
separates the favorable leverage. The traditional viewpoint has been shown in the following
figure.
Figure 7.4

Notes As per traditional approach, a firm can be benefited from a moderate level of
leverage when the advantage of using debt (having lower cost) outweigh the disadvantages
of increasing Ke (as a result of higher financial risk). The overall cost of capital Ko,
therefore, is a function of a financial leverage. The value of the firm can be affected
therefore, by the judicious use of debt and equity to capital structure.

Example: ABC Ltd., having an EBIT of 1,50,000 is contemplating to redeem a part of the
capital by introducing debt financing.
Presently, it is a 100% equity firm with equity capitalization rate, Ke, of 16%. The firm is to
redeem the capital by introducing debt financing up to 3,00,000 i.e., 30% of total funds or up to
5,00,000 i.e., 50% of the total funds. It is expected that for the debt financing up to 30%, the rate
of interest will be 10% and the equity capitalization will increase up to 17%. However, if the firm
opts for 50% debt financing, then interest will be payable at the rate of 12% and the equity
capitalization rate will be 20%. Find out the value of the firm and its overall cost of capital under
different levels of debt financing.
Solution:

On the basis of the information given, the total funds of the firm is 10,00,000 (whole of which
is provided by the equity capital) out of which 30% or 50% i.e., 3,00,000 or 5,00,000 may be
replaced by the issue of debt bearing interest at 10% or 12% respectively. The value of the firm
and its WACC maybe ascertained as follows:

Contd...

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