Page 103 - DMGT409Basic Financial Management

Basic Financial Management

Notes In other words NI approach and NOI approach represents two polar cases. The traditional or the
intermediate approach is a midway between these two approaches, because it partly takes the
features of both the approaches.
According to the theory, the value of the firm can be increased or cost of capital can be reduced by

a judicious mix of debt and equity capital. This approach states that, cost of capital is a function
of leverage. So cost of capital decreases upto a certain degree of leverages then it remains at
the same level for certain degrees of leverage and thereafter it rises sharply with the leverage.
So optimum capital structure exists when the cost of capital is minimum or value of the fi rm is
maximum.

Notes The manner in which cost of capital reacts to the changes in the capital structure
can be divided into 3 stages.
1. In the first stage, cost of equity remains constant or rises slightly with the debt. But

when it increases, it does not increase fast enough to offset the advantage of low cost
debt. Cost of debt also remains same or rises slightly with the leverage. As the cost of
debt is less than cost of equity, increased use of debt reduces the cost capital during
the 1st stage.

2. Once the firm has reached the certain degree of leverage, increased use of debt does

not result in the fall in the overall cost of capital. This is due to the fact that, benefi ts
of low cost debt are offset by the increase in the cost of equity. Within this range, cost
of capital will be minimum or value of the firm will be maximum.

3. Beyond a certain point, use of debt has unfavourable effect on cost of capital and

value of the firm. This happens because the firm would become more risky to the

investors and hence they would penalize the firm by demanding higher return. Here,

advantages of using low cost debt are less than the disadvantages of higher cost of
equity. So the overall cost of capital increases with leverage and value of the fi rm
decreases.

Illustration 3: Assume that the firm has EBIT of ` 4,00,000. The firm has 10% debentures of
` 10,00,000 and the cost of equity is 16%. Find out the value of the firm and overall cost of capital

according to the traditional approach.
EBIT (`) 4,00,000
Less: Interest (`) 1,00,000
Earnings available to ESH (`) 3,00,000
Cost of equity 0.16
Market value of the equity shares (`) NI/Ke = 3,00,000/0.16 18,75,000

Market Value of the debt (B) 10,00,000
Total Value of the firm (S + B) 28,75,000

EBIT 4,00,000
Overall cost of capital (K ) = = = 13.9%
o V 28,75,000

Now, let us assume that the firm increases the debt to another ` 5,00,000. So cost of debt increases
to 11% and cost of equity rises to 17%. Calculate the overall cost of capital and the value of the
fi rm.

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