Page 101 - DMGT409Basic Financial Management

Basic Financial Management

Notes Solution:

Net operating income (EBIT) (`) 1,00,000
Overall cost of capital (K ) 0.125
o

Total value of the firm (V = EBIT/K ) (`) 8,00,000
o
Market value of the debt (B) (Rs) 5,00,000
Total market value of the equity (S = V – B) (Rs) 3,00,000
NI earningavailabletoESH
Costofequity = =
S market valueofequityshares
EBIT − I 1,00,000 50,000
−
K = = = 16,66%
e
−
V − B 8,00,000 5,00,000
Market value of equity shares: Assuming the market price of shares to be ` 100, there are 3000
shares of ` 100 each.
If the company increases the debt from `5,00,000 to ` 6,00,000 the Ke and the value of the fi rm
are as below:

Net operating income (EBIT) (RS) 1,00,000
Overall cost of capital (Ko) 0.125
Total value of the fi rm (V=EBIT/Ko)(`) 8,00,000
Market value of debt (B) (`) 6,00,000

Market value of the equity (S) (Rs) 2,00,000
NI 40,000
Costofequity = = = 20%
S 2,00,000

Market Value of the Equity Shares

The firm has increased the debt by `1,00,000 and used the proceeds to reduce equity capital. The
number of shares has reduced from 3000 to 2000. Therefore, the price per share can be calculated
as below.
totalmarket valueof theshares
Price per share =
numberofshares
2,00,000
= = ` 100.
2000

So, there is no change in the price per share, total value of the firm and overall cost of the capital
when the leverage is changed.

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