How value of firm is calculated

Solution

The solution is given below −

Value of firm and cost of equity can be calculated by following procedure −

Market value of a firm (V) is ratio of earnings before income taxes (EBIT) and weighted average cost of capital (WACC).

V = EBIT/WACC
V = 95000/12.5%
V = 760000

Total Equity (E) is difference of market value of a firm (V) and market value of Debt (D).

E = V – D
E = 760000 – 350000
E = 410000

Cost of equity (Ke) is ratio of difference between Earnings per share (EBIT) and interest (I) to market value of equity shareholder’s (Es).

Ke= (EBIT-I)/Es
Es = EBIT – Interest on debt
Es = 95000 – 350000 (8%)
Es = 95000 – 28000
Es = 67000
Ke = (EBIT –I)/Es
Ke= Es/E
Ke = 67000/410000
Ke = 16.34%

In above example if cost of debt increases to Rs.500000/- then, calculate Ke.

V = EBIT/WACC = 95000/12.5% = 760000
E = V – D = 760000 – 500000 = 260000
Ke= (EBIT-I)/Es
Es = EBIT – Interest on debt = 95000 – 500000 (8%) = 95000 – 40000 = 55000
Ke= Es/E = 55000/260000 = 21.15%

From the above two cases, we can say that with increase in debt, cost of equity increases and market value remains constant.