Page 99 - DMGT409Basic Financial Management

Basic Financial Management

Notes Assuming the market price per share to be ` 100, there will be 4000 shares of ` 100 each. Find out
the effect of increase in leverage on the cost of capital (Ko) and value of the fi rm.
Assume that the above company increases the debt from ` 5,00,000 to ` 6,00,000 and the cost of
the debt and equity remains at the same level. We can calculate the overall cost of capital, value
of the firm and the market value of equity shares as shown below.

EBIT 1,00,000
Less: Int on debt 60,000
Earnings available to ESH ( NI) 40,000

K 0.125
e
Value of equity shares (NI/K ) = S 3,20,000
e
Value of debt (B) 6,00,000
Value of the firm (S + B = V) 9,20,000

EBIT 1,00,000
o K = = = 10.86%
V 9,20,000
Alternatively K can be calculated as below:
o
K = Kd(W1) + K (W2)
o e
6,00,000(0.10) + 3,20,000(0.125) = 10.87%
9,20,000 9,20,000

Market Value of Equity Shares

Before increasing the debt, there were 4000 ES of ` 100 each . Then the firm increased the debt by
` 1,00,000 and used the proceeds to retire equity shares. So the company redeemed 1000 shares
of ` 100 each. So the number of shares outstanding is 4000 – 1000 = 3000. Therefore, value of 1
equity share is:
3,20,000
` = ` 106.67
3000
So, the market value of equity shares has increased to ` 106.67.

To sum up, according to the NI approach, as the debt content is increased in the capital structure,
K falls, value of the fi rm increases and the market value of the equity shares also increases.
o
We can graph the relationship between K , K and K with the degree of leverage as shown
o e d
below.

Y

K
e

K
o

K
0% 50% 100% d
0 degree of leverage X

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