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.