Page 189 - DMGT207_MANAGEMENT_OF_FINANCES

Management of Finances

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

EBIT 1,00,000
K = = = 10.86%
o
V 9,20,000
Alternatively K can be calculated as below:
o
K = K (W ) + K (W )
o d 1 e 2
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,
Ko falls, value of the firm increases and the market value of the equity shares also increases.
We can graph the relationship between K , K and K with the degree of leverage as shown below.
o e d

The degree of leverage is plotted along the X-axis, while the cost of Capital in per cent is plotted
on Y-axis. As the cost of debt and cost of equity is constant with leverage, we find that both the

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