Calculate value of company with following data:nEarnings before interest tax (EBIT) = Rs.50000/-nBonds (Debt) = Rs.250000/-nCost of debt = 12%nCost 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.