Alpha Ltd is expecting an annual Earnings Before Interest and Tax of ₹1,50,000. The company had...
Alpha Ltd is expecting an annual Earnings Before Interest and Tax of ₹1,50,000. The company had 10% debentures of ₹ 5 Lakhs. Calculate the overall cost of capital of the firm if the cost of Equity is 12% assuming NI approach in the calculation. Suggest what happens to the value of the firm when more debentures are issued.
Homework Answers
Net income approach suggests that value of firm can be increased by decreasing the overall cost of capital through higher debt proportion.
EBIT 150000 Less : Interest cost 50000 (500000*10%) = 100000 i.e Earnings after tax
Market value of equity shares = Earnings after tax÷ Cost of equity. i.e 100000/12% = 833333.33
Market value of debt = 500000
Total Market value of firm = 1333333.33
Overall cost of capital in percentage = EBIT÷ Total Market value of firm =150000÷ 1333333.33 = 11.25%
When more debentures are issued the value of firm will initially increase upto a certain thereafter it will start falling.Since higher interest payment and return of shareholders ultimately affects the debt financing.
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