Calculate value of company with following data:
Earnings before interest tax (EBIT) = Rs.50000/-
Bonds (Debt) = Rs.250000/-
Cost of debt = 12%
Cost of equity = 16%

Solution

The solution is given below −

Interest cost = 12% (250000) = 30000/-

Earnings = EBIT – Interest cost = 50000 – 30000 = 20000/- (no tax rate)

Shareholders earnings = earnings
Shareholders earnings = 20000/-

Market value (equity) E = shareholder’s earnings/ cost of equity
Market value (equity) E = 20000/16%= 125000

Market value (Debt) D = 250000/-

Market value (total) = E + D
Market value (total) = 125000 + 250000= 375000/-

Cost of capital = EBIT/ market value (total)
Cost of capital = 50000/ 37500 = 13.33%

Degree of financial leverage = market value (debt)/ market value (total)
Degree of financial leverage = 250000/ 375000= 66.67%

Now, if debt increases from 250000 to 300000

Interest cost = 12% (250000) = 30000/-

Earnings = EBIT – Interest cost = 50000 – 30000 = 20000/- (no tax rate)

Shareholders earnings = 20000/-

Market value (equity) E = 125000

Market value (Debt) D = 300000/-

Market value (total) = E + D = 125000 + 300000 = 425000/-

Cost of capital = EBIT/ market value (total) = 50000/ 425000 = 11.76%

Degree of financial leverage = market value (debt)/ market value (total) = 250000/ 425000 = 58.82%

From above two cases, we can conclude that if there is an increase in debt, there will be an increase in value of firm and decrease in cost of capital.

Mandalika

Updated on: 28-Sep-2020

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