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UNIT 2: PART I

COST OF CAPITAL

➔ Introduction:

The company may raise funds through debts, equity share or preference share. It may
use retained earnings of equity in the business. Each component has cost to the
company and it is called as cost of capital (component wise).

According to James. C. Van Horne “Cost of Capital is a cut off rate for allocation of
capital to investments of projects. It is the rate of return on a project that will leave
unchanged the market price of the stock”.

According to Solomon Ezra “Cost of Capital is the minimum required rate of

earnings or the cut off rate of capital expenditures”.

➔ Basic Definitions:
The items on the right side of the firm’s Balance sheet – various types of debt,
preferred stock and common equity are called capital components. Any increase in
total assets must be financed by an increase in one or more of these capital
components.

Kd = interest rate on the firm’s new debt = before tax component cost of debt.

Kd (1-t) = After tax component cost of debt where, t is the firm’s marginal tax rate
(used to calculate weighted average cost of capital)

Kp = Component cost of preferred stock

Ke = Component cost of common equity.

Equity capital is raised in 2 ways:
1.By retaining earning (internal equity)
2. By issuing new common stock (external equity)

➔ Weighted Average Cost of Capital (WACC):

If a co. raises new capital to finance asset expansion and if it is to keep its capital
structure in balance (i.e., if it is to keep the same percent of debt, preferred stock and
common equity funds) then it must raise part of its new funds as debt, part as

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preferred stock and part as common equity (with equity coming from retained
earnings or issuing new common stock)

➔ Significance of cost of capital:

->As an acceptance criterion in capital budgeting –
The concept of cost of capital has assumed growing importance largely because of
the need to device a rational mechanism for making the investment decisions of the
firm.

->As a determinant of capital mix in capital structure decision-

While designing optimal capital structure the mgt. has to keep in the mind the
objective of maximising the cost of capital. Measuring of cost of capital from various
sources is very essential in planning the capital structure of any firm.

->As a basis for evaluating the financial performance-

The concept of cost of capital can be used to evaluate the financial performance of
top mgt. The actual profitability of the project is compared to the projection overall
cost of capital and the actual cost of capital of funds raised to finance the project. If
the actual profitability of the project is more than the projected the performance
maybe said to be satisfactory.

->As a basis for taking other financial decisions-

The cost of cap. Is also used in making other financial decision such as dividend
policy, capitalisation of profits, making the rights issue and working capital.

➔ Classification of cost:

->Historical and future cost- Historical costs are book costs which are related to the
past. Future costs are the estimated cost for future.

->Specific and composite cost- Specific cost refers to a cost of the specific source of
cap. Such as cost of debt, cost of equity, cost of preference share etc. Composite cost
is combined cost of various sources of capital. It is the weighted average cost of
capital (WACC)

->Explicit and Implicit cost- Explicit cost is the discount rate which equates the
present value of CIF’s with PV of COF’s. In other words, it is the IRR. Implicit cost
is also known as the opportunity cost which means the cost of the opportunity
foregone in order to take up a particular project.
For ex. The implicit cost of retained earnings is the rate of return available to
shareholders by investing the funds elsewhere.

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->Average cost and Marginal Cost- An average cost refers to a combined cost of
various sources of capital such as debentures, preferences and equity shares.
Marginal cost of capital refers to the avg. cost of capital which has to be incurred to
obtain additional funds required by a firm, in investment decisions it is the marginal
cost which should be taken into consideration.

→ Problems in determination of cost of capital-

1. Conceptual controversies regarding the relationship b/w cost of capital and capital
structure.
2. Problem of choice between historic and future cost
3. Problems in computation of cost of equity.
4. Problems in computation of cost of retained earnings
5. Problems in assigning weights
➔ Computation of cost of capital –
Computation of overall cost of a firm involves:
→Computation of cost of specific source of finance
→Computation of weighted avg. cost of capital
→Computation of specific source of finance
Computation of each source of finance that is debt, P/S, E/S and retained earnings.

→Cost of debt

→Cost of irredeemable debt- The cost of debt is the rate of interest payable on debt.

Before tax cost of debt can be calculated by the formula

Kdb = I

P Kdb=Before tax
Cost of debt
I = Interest
P = Principle

In case if the debt is raised at premium or discount, the formula is

Kdb = I
NP NP = Net proceeds

The after-tax cost of debt can be calculated by:

Kda = I (1-t)
NP t = Tax rate

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1) X ltd issues Rs 50,000 8% debentures at par, the tax rate applicable to the co. is 50%.
Compute the cost of debt capital.
2) Y ltd issues Rs 50,000 8% deb at a premium of 10%. The tax rate applicable to the co.
is 60%. Compute cost of debt.
3) A ltd. Issues Rs 50,000 8% deb at discount of 5%. The rate is 50%. Compute the cost
of debt.
4) B ltd issued Rs1,00,000 9% deb at premium of 10%, the cost of flotation is 2% the tax
rate is 60%.
5) Vishnu steels ltd has issued 30,000 irredeemable 14% deb. Of Rs 150 each, the cost of
flotation of debentures is 5% of the total issue amount. The co’s tax rate is 40%.
Calculate cost of capital.

➔ Cost of redeemable debt – The debt is issued to be redeemed after a certain period during
the lifetime of the firm. Such a debt is known as redeemable debt. The cost of redeemable
debt can be computed by using the following formula.

->Before tax cost of redeemable debt will be calculated by:

Kdb = I + 1/n (RV-NP)
½ (RV + NP)

Where, I = Annual Interest

N= No. of years in which the debt is to be redeemed
RV= Redeemable value of debt (face value)
NP = Net proceeds of debenture

->After tax cost of redeemable debt will be calculated by:

Kda = I (1-t) + 1/n (RV-NP)
½ (RV + NP)
Where, t = tax rate

1) A co. issues Rs 10,00,000 10% Redeemable debentures at a discount of 5%. The cost
of flotation amounts to Rs 30,000. The debentures are redeemed after 5 years.
Calculate before tax and after-tax cost of debt assuming tax rate of 50%.

2) A 5 year 100 Rs Debenture of a firm can be sold for a net price of Rs 96.50 the
coupon rate of interest is 14% p.a. The debenture will be redeemed at 5% on premium
on maturity. The firm’s tax rate is 40%. Compute the before tax and after-tax cost of
debenture.

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3) A co. issues 5000 12% deb at Rs100 each at discount of 5%. The com. Payable to v/w
and brokers is Rs 25,000. The deb. is redeemable after 5 years. Compute after tax cost
of debt assuming tax rate of 50%.

4) Assuming that a firm pays tax at 50% rate, Compute after tax cost of debt in the
following cases:
i) A perpetual bond of Rs100 sold at par with the coupon rate of interest 7%
ii) A 10 years 1000 Rs bond sold at Rs950 less underwriting commission 4%

5) A co. issues Rs10,00,000 12%debentures of Rs100 each. The debentures are

redeemable after the expiry of fixed period 7 years. The co. is in the tax bucket of
35%. Calculate the cost of debt after tax if debenture is issued at par, 10% dis, 10%
premium. If brokerage is paid at 2%, what will be the cost of debenture if issue is at
par?

➔ Cost of preference shares (Kp)

A fixed rate of dividend is paid on preference share. The cost of preference
capital which is perpetual (irredeemable) can be calculated as:
Kp = D or D
P NP
➔ Where, (Kp) is cost of preference share/ capital
D is annual preference dividend
P/NP is preference share capital (proceeds)

When the preference shares are redeemed or cancelled on maturity date, they are redeemable
preference share. The cost of redeemable preference share can be calculated as:

Kp = D + 1/n (RV – NP)

½ (RV +NP)
Where, Kp = cost of redeemable p/s
D = Annual preference dividend
MV/RV = Maturity value/Redeemable value
NP = Net proceeds of p/s

1) A co. issues 10,000 10% p/s at of Rs100 each. Cost of issue is Rs2 share. Calculate
cost of preference capital if these shares are issued
->At par ->At premium at – 10%
->At discount of 5%.

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2) A co. issues 10,000 10% p/s of Rs100 each redeemable after 10 years at a premium of
5%. The cost of issue is Rs2 per share. Calculate the cost of p/s.
3) A co. issues 1000 7% p/s of Rs100 each at premium 10% redeemable after 5 years at
par.
4) A co. issues 1000 10% p/s of Rs100 each at a discount of 5%. Cost of raising capital
are Rs2000. Compute the cost of preference capital.
5) Assume that the firm pays tax at 50%. Compute the cost of preferred capital, where
p/s is sold at Rs100 with a 9% dividend and redemption price at Rs110 if the co.
redeems it in 5 yrs.

➔ Cost of equity share capital (Ke):

The cost of equity is the maximum rate of return that the co. must earn an equity
financed portion of its investments in order to have unchanged the market price of its
stock.

Dividend yield method/Dividend price ratio method:

According to this method the cost of e/s capital is the discount rate that
equates the present value of expected future dividends per share with the net proceeds
or current market price of a share.
Ke = D or D
NP MP
Where, Ke is cost of equity capital
D is expected dividend per share
NP is net proceeds
MP is market price

1) A co. issues 1000 e/s of Rs100 each at a premium of 10%. The co. has been paying
20% dividend to e/s holders for the past 5 years and expects to maintain the same to
the future also. Compute the cost of equity capital, will it make any difference, if the
market price of e/s is Rs160?

2) X is a shareholder of ABC co. ltd although earnings for ABC ltd. Have varied
considerably. X has determined that the long run avg. div. of the firm have been
Rs2/share. He expects a similar pattern to prevail in the future. Give the volatility of
ABC dividends X has decided that a minimum rate of 20% should be earned on his
share. What price would X be willing to pay for ABC ltd share?

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➔ Dividend yield + growth method: When the dividend of the firm is expected to grow
and dividend pay-out ratio is constant this method maybe used to compute the cost of
capital
Ke = D1 + G or Dn = (1 + g) + G
NP NP
Where, Ke = cost of eq. capital
D1 = Expected div. per share/end of yrs
NP= Net proceeds/share
G = Rate of growth in dividend
Do = Previous year dividend.

Further, in case cost of existing e/s capital is to be calculated, the net proceeds should
be changed with market price/share in the above equation.

Ke = D1 + G Or Dn(1 +g) + G

MP MP

1) A co. plans to issue 1000 new shares of Rs100 each at par the flotation cost is
expected to be 5% of share price. The co. pays dividend of Rs10/share initially and
growth in dividends is expected to be 5%. Compute the cost of new issue of e/s
->If the current market price of e/s is Rs150. Calculate the cost of existing eq. share
capital

2) The share of company is selling at 40Rs/share and it had paid dividend of Rs4/share
last year, the investor’s market expects a growth rate of 5% per year
->Compute the cost of equity capital
->If anticipated growth rate is 7% p.a. Calculate the indicated Market price per share.

3) Your company’s share is quoted in the market at Rs20 currently. A co. pays div of
1Rs per share and the investor’s market expects the growth rate of 5% per year.
->Compute co’s equity cost of capital
->If anticipated growth rate is 6% p.a. Calculate the indicated market price/share.
->If the co’s cost of cap. Is 8% and the anticipated growth rate is 5% p.a. Calculate
the indicated market price if the div. of Rs1 per share is to be maintained.

➔ Earning yield method or Earning price ratio:

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According to this method the cost of equity capital is the discount rate that equates the
P.V of expected future earnings per share with the net proceeds or current market
price of share.

Symbolically - Ke = EPS
NP
The cost of existing capital can be calculated by
Ke = EPS
MP

1) A firm is considering an expenditure of 60 Lakhs for expanding its operations. The

relevant information is as follows
Particulars Amount (Rs)
No. of existing e/s 10,00,000
Market value of existing share 60
Net earnings 90,00,000
Compute the cost of existing e/s capital assuming that new shares will be issued at a
price of Rs52/share and cost of new issue will be Rs2 per share.

➔ Realised yield method: - It takes into a/c the actual average rate of return realised in the
past to compute the cost of equity share capital to calculate the average rate of return
realised, dividend received in the past along with the gain realised at the time of sale of
shares should be considered. The cost of equity capital is said to be the realised rate of
return by the shareholders. This method is based on following assumptions:
1) The firm will remain in the same risk class over the period
2) The shareholder’s expectations are based on the past realised yield
3) The investor’s get the same rate of return as the realised yield even if they invest
elsewhere
4) The market price of share does not change significantly.

➔ Cost of retained earnings: -

It may be considered as the rate of return which the existing shareholders can obtain
by investing after tax dividends in alternative opportunity of equal qualities. It is thus
the opportunity cost of dividends foregone by the shareholders. The cost of retained
earnings can be calculated by using the formula,
Kn = D1 + G or D1 + G
MP NP
To make adjustment in the cost of retained earnings for tax and cost for purchasing
new securities the following formula maybe adopted:
Kr = Ke(1-t) (1-b)

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Where, t = tax rate

b = brokerage/cost of purchasing new sec.

1) A firm’s cost of equity is 15% the average tax rate of shareholders is 40% and it is
expected that 2% is brokerage cost that shareholders will have to pay while investing
their dividends in alternative securities. What is the cost of retained earning?

➔ Weighted Average Cost of Capital: - It’s the avg. cost of the costs of various sources of
financing. It is also known as composite cost or overall cost or average cost of capital.
Once the specific cost of individual sources of finance is determined we can compute
WACC by putting specific weights to the specific cost of capital in proportion of the
various sources of funds to the total. The weights maybe given either by giving book
value of the source or market value of the source.
Kw = ∑XW
∑W
Where, Kw= Weighted cost of capital
X= Cost of specific source of finance
W= Weight/proportion of specific source.

1) Capital of a co. consists of Rs10,00,000 in equity funds and 15,00,000 in 10% debt.
The rate of return required by holders of equity is 20%. Compute WACC using the
proportion of debt and equity funds.

2) A firm has the following capital structure and after-tax cost for the different sources
of funds
Sources of funds Amount (Rs) After tax cost
Debt 15,00,000 5%
Preference shares 12,00,000 10%
Equity shares 18,00,000 12%
Retained earnings 15,00,000 11%
You are required to compute WACC.

3) A Firm has following Capital structure and after-tax cost for different sources of
funds. Compute WACC.
Sources of funds Amount (Rs) After tax cost (%)
Debt 12,000 4%
P/S 15,000 8%
E/S 18,000 12%
R/E 15,000 11%

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4) A co. has on its book the following amounts and specific cost of each type of capital

Type of capital Book Value Market Value Specific cost

Debt 4,00,000 3,80,000 5%
P/S 1,00,000 1,10,000 8%
E/S 6,00,000 9,00,000 15%
R/E 2,00,000 3,00,000 13%
Determine WACC using book value weights and market value weights.

5) ABC ltd has following cap. Structure

Particulars Market Value Book Value Cost
E/S 80,00,000 1,20,00,000 18%
P/S 30,00,000 20,00,000 15%
Fully secured
Debentures 40,00,000 40,00,000 14%
Compute company’s WACC.

6) XYZ has following capital structure

Particular B. V M.V Cost (%)
E/S capital 10,00,000 20,00,000 18%
Retained earnings 5,00,000 - 15%
14% P/s capital 7,00,000 7,00,000 14%
12% Debentures 6,00,000 6,00,000 8%
Calculate WACC

7) Capital structure of ABC ltd.

Particulars BC MV Cost (%)
Debt 40,000 38,000 5%
P/S cap 10,000 11,000 8%
E/S cap 60,000 1,20,000 13%
R/E 20,000 - 9%
Calculate WACC, under
i)BV as weights
ii)MV as weights

8) The following is capital structure of company

Sources of capital BV in Rs MV in Rs
E/S at Rs100 each 8,00,000 16,00,000
9% cumulative P/S
at Rs100 each 2,00,000 2,40,000

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11% Debentures 6,00,000 6,60,000

Retained earnings 4,00,000 -
20,00,000 25,00,000
The current price of the company’s E/S is Rs200 for the last year the co. had paid
equity dividend at 25% and its dividend is likely to grow 5% every year. The
corporate tax is 30% and shareholders personal income tax rate is 20%. You are
required to calculate:
i)Cost of capital for each source of capital
ii)WACC on book value weights
iii)WACC on market value weights

9) JK ltd has the following book value capital structure as on march 31st 2018:
Eq. share cap. 40,00,000
11.5% P/S 10,00,000
10% debentures 30,00,000
80,00,000
The equity share of the company sells for Rs20; it is expected that the company will
pay dividend of Rs2 per equity share next year which is expected to grow at 5%
assume tax rate at 35% calculate WACC based on existing capital structure.

10) Calculate WACC of XYZ ltd from the following:

i)Sources of funds Amount (Rs) Cost (%)
E/S 15,00,000 20%
P/S 6,00,000 15%
R/E 3,00,000 10%
LTD 6,00,000 10%
ii)The current MP of E/S is Rs80
The current dividend per share is Rs5 and dividends are expected to grow at 6%.
Calculate cost of equity.

11) From the following information determine WACC using BV and MV weights
Sources of funds BV(Rs) MV(Rs) Cost (%)
E/S 3,00,000 6,00,000 15%
R/E 1,00,000 - 13%
P/S 50,000 60,000 8%
Debt 2,00,000 1,90,000 6%

12) SK ltd has obtained funds from the following sources. The specific costs are also
given against them
Sources of funds Amount (Rs) Cost (%)
E/S 30,00,000 15%
P/S 8,00,000 8%

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R/E 12,00,000 11%

Debentures 10,00,000 9% (before tax)
You are required to calculate WACC, assume that corporate tax rate is 30%.
13) The capital structure of ABC ltd is as under
Sources of funds Amount in Rs
9% Debentures 2,75,000
11% P/S 2,25,000
E/S (FV Rs10/share) 5,00,000
10,00,000
->Rs100/Debenture redeemable at par has 2% flotation cost and 10 years of maturity
the MP for per debenture is Rs105.
->Rs100/ p/S redeemable at par has 3% flotation cost and 10 year of maturity. The
MP P/S is Rs106.
->Equity share has Rs4 as flotation cost and MP/share is Rs24. The next year
expected dividend is Rs2 per share with annual growth of 5%.
A firm has the practise of paying all the earnings in the form of dividends.
->Corporate income tax rate is 35%.
->Calculate WACC using market value weights.

14) The capital structure of XYZ ltd. Is as under

Sources of funds Amount (Rs)
9% deb of Rs100 each 5,50,000
11% P/S of Rs100 each 4,50,000
E/S of Rs10 each 10,00,000
20,00,000

->Rs100 per Deb. redeemable at par has 4% flotation cost and 10 years of maturity.
The MP per Deb is Rs106.
->Rs100 per p/s redeemable at par has 2% flotation cost and 10 years of maturity. The
MP / p/s is Rs107
->The E/S has MP per Share of Rs20, the next years expected dividend is Rs2 per
share with annual growth of 5%. The firm has practise of paying all earnings in the
form of dividend
->Corporate Income tax rate is 35%
You are required to calculate
i)Cost of each source of capital
ii)WACC using MV weights.

➔ Marginal cost of capital: -

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It is weighted average cost of new capital calculated by using the marginal weights.
The marginal weights represent the proportion of various sources of funds to be
employed in raising additional funds.

1) A firm has following capital structure and after-tax cost for different sources of funds
Sources of funds Amount (Rs) Proportion (%) After tax cost (%)
Debt 4,50,000 30 7
P/S cap 3,75,000 25 10
E/S cap 6,75,000 45 15
15,00,000 100
i)Calculate WACC using B.V weights
ii) The firm wishes to raise further Rs6,00,000 for the expansion of project as below:
Debt 3,00,000
P/S cap 1,50,000
E/S cap 1,50,000
Assuming that specific cost does not change. Calculate weighted marginal cost of
capital.

➔ Cost of equity using capital asset pricing model (CAPM)

The value of an equity share is a function of cash inflows expected by the investors
and the risk associated with the cash inflows. It is calculated by discounting the future
stream of dividends at the required rate of return called the capitalisation rate.
According to CAPM, the premium for risk is the difference between the market return
from a diversified portfolio and the risk-free rate of return. It is indicated in terms of
B co efficient. Thus, according to CAPM the cost of equity can be calculated as
below:

Ke = Rf + β i (Rm – Rf)

Rf = Risk free rate

β i=Risk of 1 security

Rm= Expected market return.

1) Calculate cost of equity using CAPM model:

Rf =10% Rm=16% β=1.50

2) Calculate expected return on portfolio using CAPM model:

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Rm=16% Rf=9% β =0.8

3) You are given with risk free return and expected market return in respect of a no. of
projects which are as follows:
Project Risk free return Expected market return β
1 5 7.50 1
2 7 10 1.50
3 5.50 9 0.90
4 4.50 8 1.40
What is the required return of equity in each project under CAPM?

UNIT 2: PART II
CAPITAL STRUCTURE THEORIES
→NET INCOME THEORY: -

Under this approach the value of the firm can be ascertained as below:

V=S+D

S = EAES(NI)

Ke

Where, V = Total market value of firm

S = M.V of E/S

D = M.V of debt

NI = Net income

Ke = Equity capitalisation rate

Overall cost of capital /WACC can be calculated as: -

Ko = EBIT

1) X ltd is expecting an annual EBIT of Rs1,00,000. The co. has Rs4,00,000 in 10% deb
the cost of equity capital or capitalisation rate is 12.5%. You’re required to calculate
the total value of the firm according to Net income approach.

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2) A co. expects a net income of Rs80,000 it has Rs2,00,000 8% debentures, the eq.
capitalisation rate is 10% ->Calculate the value of the firm and overall capitalisation
rate according to net income approach (ignoring income tax)
->If the debenture is increased to Rs3,00,000, What shall be the value of firm and
overall capitalisation rate.

3) ABC Co. is expecting an EBIT of Rs1,00,000 and its equity capitalisation. Rate is
12.5% Currently a co. has a debt of Rs4,00,000 at 8% ->Calculate the value of the firm and
cost of capital according to net income approach. ->What is the value of the firm and cost of
capital if the debt is increased by 2,00,000 and decreased by 2,00,000.

4) A co. expected annual debt operating income is Rs1,00,000 and it has 3,00,000 10%
Debentures the Ke is 12% ->Calculate the value of the firm and overall capitalisation rate
under net income approach.

->Find out the impact of the value of the firm and overall capitalisation rate if the debt
component is increased to Rs4,00,000 and if the debt component is decreased to Rs2,00,000
assuming Kd (cost of debt) remains same

➔ NET OPERATING INCOME APPROACH

➔ The value of the firm on the basis of NOI approach can be determined by:
V = EBIT/NOI
Ko
Where, V = Value of the firm
EBIT = NOI
Ko = Overall cost of capital
The market value of eq. acc to this approach is residual value which is determined by
deducting the M.V of debenture from the total MV of the firm.
S= V – D
S= MV of eq. shares
D = MV of debt
V = MV of firm
Ke can be calculated as below (cost of equity or equity capitalisation rate)
Ke = EBIT – I
V-D

1) A) A co. expects NOI of Rs1,00,000 it has Rs5,00,000 6% deb. the overall

capitalisation rate is 10%. Calculate the value of the firm and equity capitalisation rate
(ke) according to NOI approach.
b) If the debenture debt is increased to Rs7,50,000 what will the effect on the value of
the firm and equity capitalisation rate.

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2) HPV ltd. Expects annual net op. income of Rs2,00,000. It has 5,00,000Rs o/s debt,
cost of debt is 10%, if the overall capitalisation. Rate is 12.5% what will be the total
value of the firm and equity capitalisation. Rate according to NOI approach.
What will be the effect of the following on the total value of the firm and equity
capitalisation rate if-?
a) The firm increases the amt. of the debt from 5,00,000 to 7,50,000 and uses the
proceeds of the debt to repurchase equity shares.
b) The firm’s redeems debt of Rs2,50,000 by using fresh E/S of the same amount.

3) ABC co.ltd cost of capital(ke) is 12.5% and expecting an operating profit of

Rs1,00,000. The company has a debt of Rs4,00,000 at 8%. You are required to
calculate total value of the firm of equity value of cost
a) The company increases debt from 4,00,000 to 6,00,000
b) The company reduces debt to 2,00,000

What is the value of the firm and Ke ?

4) A co. expects a NOI of Rs2,00,000 It has Rs8,00,000 6% deb. The overall

capitalisation rate is 10% Calculate the value of the firm and Ke according to NOI
approach. If the deb. debt is increased to Rs10,00,000 what will be the effect on the
value of the firm and cost of equity?

5) There are 2 firms A and B which are identical expect that A does not use any debt in
its financing while B has 2,50,000 6% Debentures in its financing both the firms have
EBIT of Rs75,000 and cost of equity is 10% Assuming the corporate tax at 50%.
Calculate the value of the firm.

→TRADITIONAL APPROACH: It is also known as intermediate approach.

1) Compute the MV of the firm, MV of shares and average cost of capital from the
following info.
NOI 2,00,000
Total investment 10,00,000
Equity capitalisation rate
->If firm uses no debt 10%
->IF firm uses 4,00,000Rs of debentures 11%
->If firm uses 6,00,000Rs of debentures 13%

Sushmitha V, Asst Professor, Dept of Commerce and Management, MESIOM

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Assume that Rs4,00,000 debentures can be raised at 5% rate of interest whereas

Rs6,00,000 debentures can be raised at 6% rate of interest

→MODIGLIANI-MILLER APPROACH (MM APPROACH)

MM hypothesis is identical with NOI approach if taxes are ignored, however when corporate
taxes are assumed to exist, their hypothesis is similar to NI approach.

->In the absence of tax- Theory of irrelevance

1) The following info is available regarding ABC ltd.

->currently it has no debt and is and all equity company.
->Expected EBIT is Rs24,00,000 and it is not expected to increase overnight. So,
ABC ltd is in no growth situation
->There are no taxes
->If pays out all its income as dividends
->If ABC ltd begins to use debt it can borrow at the rate of 8% (kd = 8%). This
borrowing rate is constant and independent of the amount of debt. Any money raised
by selling debt would be used to retire common stock, so ABC ltd.’s assets would
remain constant
->The risk of ABC ltd.’s assets and thus its EBIT is such that its shareholders require
a rate of return at 12% (ke = 12%) if no debt is used.
Used mm model without using corporate taxes and assuming debt of 1 crore, you are
required to
a) Determine firm’s total value
b) Determine the firm’s value of equity
c)Determine the firm’s leverage cost of equity.

2) There are 2 firms X and Y are identical expect that X does not use any debt in his
financing Y has Rs1,00,000 5% debenture in its financing Y has Rs1,00,000. 5%
debenture in its financing both the firms have EBIT of Rs25,000 and the equity
capitalisation rate is 10% assuming the corporate tax 50%. Calculate the value of the
firms using MM approach.

3) The firms A and B are identically in all respects including risk factors expect for debt
equity mix. Firm A has issued 12% deb of Rs15,00,000 while ‘B’ has issued only
equity both the firms earn 30% EBIT on these total assets of Rs25,00,000 Assuming
tax rate of 50%. Capitalisation rate of 20% and all equity company you’re required to
compute
i) Net Income Approach
ii) MM Approach

Sushmitha V, Asst Professor, Dept of Commerce and Management, MESIOM

AFM Unit: 2 P a g e | 18

4) From X and Y are identically in every respect expect that Y is levered X and is
unlevered company Y has Rs20,00,000 and 8% Debentures outstanding. Assume that
all MM assumptions are applied and tax rate is 50% with EBIT of Rs6,00,000 and
equity capitalisation rate for company is 10%.

5) Company X and Y are identically in all the respects including risk factors respect for
debt equity. X having issued 10% debentures of Rs18,00,000 while Y has issued only
equity both the companies earn 20% EBIT on these total assets of Rs30,00,000
assuming the tax rate of 50% and capitalisation of 15% for an all-equity capitalisation
of 15% for an all equity. Compute the value of firms using NOI and MM approach

ASSIGNMENT QUESTIONS
1. A company’s annual NOI is Rs 1,00,000 and it has Rs 3,00,000, 10% debentures. The
equity capitalisation rate is 12%.
a. Calculate the value of the firm and overall capitalisation rate under NOI approach
b. Find out the impact of the value of the firm and overall capitalisation rate if the
debt component increased to Rs4,00,000 and if the debt component decreased to
Rs 2,00,000 assuming cost of debt remaining same.

2. Which of the following is the capital structure theory?

a. NI approach
b. Traditional approach
c. MM approach
d. All of the above

3. What do you mean by WACC?

4. A. Rao corporation has a target capital structure of 60% equity and 40% debt. Its cost
of equity is 18% and pre-tax cost of debt is 13%. If the relevant tax rate is 35%, what
is Rao corporation WACC?
B. Calculate the Ke, whose shares are quoted at Rs 120. The dividend at the end of the
year is expected to be Rs 9.72 per share and the growth is 8%.

5. From the following data determine the value of the firm P and Q belonging to
homogeneous risk class under NI approach.

Particulars Firm P Firm Q

Sushmitha V, Asst Professor, Dept of Commerce and Management, MESIOM

AFM Unit: 2 P a g e | 19

EBIT Rs 225000 Rs 225000

Interest 15% Rs 15000 -

Ke =0.20, Tax rate =0.35. Which of the two firms has optimal capital structure ?

6.Give the formula for cost of redeemable debt

7. What is specific cost of capital?

8. The following details are furnished by Gama Ltd.

Particulars Amount (Rs)

E/S Capital 65,00,000

12% P/S Capital 12,00,000

15% redeemable debentures 18,00,000

10% convertible debentures 10,00,000

Ke = 17.20%, t = 0.35, WACC =?

9.From the following info calculate:

Type of capital Book Value (Rs) Market Value (Rs) Specific Cost (%)
Debentures 40,000 38,000 5
P/S Capital 10,000 11,000 8
E/S Capital 60,000 1,20,000 13
RE 20,000 - 9
WACC as Book Weights and Market Weights.

10. What do you mean by capital structure?

11. Write the importance of capital structure

12. Explain NOI approach

13. What are the pros and cons of using dividend growth model approach to calculate Ke?

Sushmitha V, Asst Professor, Dept of Commerce and Management, MESIOM