GRADED ILLUSTRATIO NS / EXAMINATIO N QUESTIONS

Ill11stration 1. • A company has EBIT of f 4,00,000. The capital structure of the company is having debt Gf
f 5,00,000 borrowed at the rate of 8%. Cost of equity capital is 12%. Find
(1) Total value of the firm and overall cost of capital using Net Income Approach.
(i,) Value when debt is increased by, 2,00,000.
(ii,) Value when debt is decreased by, 2,00,000.
Solution: Statement Showing Value of the Firm (Net Income Approach)

Particulars . Existing When Debt Increases When Debt Deel•

by (' 2,00,000 •. by (' 2;
Debt 5,00,000 7,00,000 3,00,000
EBIT 4,00,000 4,00,000 4,00,000
Less Interest 40,000 56,000 24,000
Earnings for shareholders (NI) 3,60,000 3,44,000 3,76,000
Cost of equity (k.) 12% 12% 12%
.Market value of equity (E) = NI I k• 30,00,000 28,66,666.7 31,33,333.3
Market value of debt (D) (given) 5,00,000 7,00,000.0 3,00,000.0
Value of the finn (V) = (E + D) 35,00,000 35,66,666.7 34,33,333.3

EBIT)
Overall cost of capital ( ~ 11.4% 11.2% 11.65%

Therefore, from the above, it can be observed that the increase in debt has led to increase in the value of the
firm and decrease in the overall cost of capital and vice-versa.
Illustration 2. Two firms X and Y are identical in all respects including risk factors except for debt/equity.X
has issued 10% debentures off 18 lakh while Y has issued only equity. Both the firms earn 20% before the
interest and taxes on their total assets of f 30 lakh.
Assuming a tax rate of 50 percentage and capitalization rate of 15 percentage for an all equity firm. Compute
the value of companies X and Y using net income approach.
[B. Com (Hons) Delhi University, 2003 & CA (F) Nw. J99'
Solution: Valuation as per Net Income Approach f
. Particulars ~ ,
FinnX

eerr(30,00,000x 1:) 6,00,000 6,00,000

Less Interest
EBT 4,20,000
1,80,000 -
6,00,000
Less Taxes (50%) 3,00,000
2, 10,000
Earnings available for equity shareholders (NI) 3,00,000
2,10,000
Cost of equity (k.J (given) 15ft
15%
Mark~t value of equity (E) = NI / k• 20,00,000
14,00,000
Market value of debt (D) (given)
18,00,000
Total value of the finn (V) = (E + D) 32,00,000 11 t t I
 ABC Ltd. has all equity capital structure with a cost of capital of 15%. The company decides to
o1 debt and use the proceeds to retire equity. The expected level of EBIT is, 90,000
3. which is
rnnn1 1270 • t. ch calculate value of
i,vvv • unchanged. Assum.mg ne income approa assumptions are applicable,
~ to resnain d the value of firm before and after change in capital structure Also calculate
~~~~
weighted
.
' ~ of capital after the change. . . •
,;,,,.,,ecost . [B. Com (H), Delhi University 2005 (R))
Statement of computation of value of firm as per NI approach and WACC
50
-·
i,,tio,s:
--.. _,._.,;.,,;:..._
.
.·
·,• ~ · Particulars
,••

-<
All equity . ...
. '
, ...~"' ..
~

. . . .---:· •••
90,000 90,000
(a)EBIT ~ 24,000
(b) lnW8~ available for equity shareholders (NI) 90,000 68,000
(c) ea,n.. ,. 15% 15%
(d) cast of equity (k.)
I ) Market value of equity (E) = Nl/ke 6,00,000 4,40,000
(~ Market value of debt (D) (given) ~ 2,00,000
(g) Total value of flnn (V) = ( E + D) 6,00,000 6,40,000

(h)k.,= yEBIT ~ 100

15% 14.06%

Hllllffllti011 4. The management of SR Ltd. subscribing to the net operating income approach, believes that
its cost of debt and overall cost of capital will remain at 8% and 12% respectively. If the equity shareholders of
the firm demand a return of 20%, what should be the proportion of debt and equity in the firms capital
structure? Assume that there are no taxes. (Calcutta Unit1asity 2003)
Sol,,tion: According to Net Operating Income Approach:
D D
ke =k0 + (k0 - kd) E , (where E =Debt-equity ratio)
D D
20% = 12% + c12% - 8%) E ⇒ 20% - 12% = (4%) E
8% D
E = 4% =2
Therefore, the desired debt-equity ratio is 2: 1. Let us verify the result by calculating k0

k0 =k,x W, +k4 x W4 = 20%xG) +8%G)

= ( 320) 0
Yo + (16)
3 Yo =12%
0
Hence, verified.

~ 5• Two finns X and Y are implementing the same project withThedebts of ,soo Jakhs and, 700 lakha
lnlereat .J· expected level of earnings befare
The cost of debt for X and Y are 12% and 15% respectively.
lllt of 35%. taxes from these projects are , 300 Lakhs annually. Both the firms are subject to income tax at
1.
2. Pinet the amount of earnings available for the shareholders of each firm.
Find
1-1.out the value of equity, value of the
firm and the overall cost of capital for both --....-ft. .
of NI approach when costs of equity for firm X and firm Y are 22% and 24,C,
• [B.O.(ltq~
 Soluti on: Calculation of Earni ngs for Equit y Share holde rs and
Value of the firms as per
Finn X (f lalchaJ
EBT 300.00
lea Interest ( 12% and 15% respectively) 300.00
60.00 105.00
EBT 240.00
less Tax (35%) 195.00
84.00 68.25
Earning for equity shareholders (NI)
156.00 126.75
Cost of equity (k.)
22% 24%
NI
value of equity (E) = k 709.09
• 528.13
Value of debt (D)
500.00 700.00
Total value (V) = (E + D)
1,209.09 1,228.13
Overall cost of capital (k0 ) = k• >e w. + kJ1 - t) wJ
>e 16.13%. 15.87%

709.0 9 500.0 0
Note: k0 of Firm X = 22 % x
1,2 0 9.09 + 12% (1 - 0.35) x
1,209 .09 ⇒ 12.9022% + 3.2256% =16.13%.
528.1 3 700.0 0
Note: k0 of Firm Y = 24 % x l, _1 + 15% (1- 0.35)
228 3 x l, 228 _1 3 ⇒ 10.3207% + 5.5572% = 15.87%
Illustr ation 6. A comp any has an EBIT of? 3,00,000 and overall cost
of capital 12.5%. The company has debtu
, 5,00,000 borro wed at the rate of 8%. Find the value of the company
using NOI approach and show using NC
approach, how chan ~ in debt by, 3,00,000 have impact on the cost of
equity capital of the company.
[B.Com (H), Sem- V, Delhi Univ. Nou. 2013
Soluti on: Valua tion of firm as per NOi Appro ach r
Particulars Existing When Debt Increases
.. When Debt
by r 3, 00,000 .· by f' 3,

Debt 5,00,000 8,00,000 2,00,000

Cost of debt
8% 8% . 8%
EBIT 3,00,000 3,00,000 3,00,000
Overall capitalisation rate (k ) 12.5%
0 12.5% 12.5%
EBIT)
Market value of the firm (V) = ( ~ 24,00,000 24,00,000 24,00,000
Market value of debt (D) 5,00,000 8,00,000 2,00,000
Market value of equity (E) = (V - D) 19,00,000 16,00,000 22,00,000 •
Interest (I) 40,000 64,000 16,000
Earnings for shareholder (EBIT - I) 2,60,000 2,36,000 2,84,000
k•= (EB~ -1) 13.68% 14.75% 12.91%

In the above illustration, we obser ve that the chang e in debt propo rtion
in the total capital structure
affect the total mark et value of the firm. The cost of equity increases with
the increase in proportion of
the capita l struct ure.
 except that
Company X and Compa ny Y are in the same risk class and identical in all respects
t,iitio1t 1.
compan ies eam 8
Ill::es debt of , 2,00,000 carrying an interest of 12%, wherea s X is an all equity firm. Both
~ of 20% on their assets of, 4,50,000.
Calculate the value of both the companies and their overall cost of capital under
the net income
(i)
approach taking cost of equity as 15%.
NOi approach taking
(i,) Calculate value of both the companies and equity capitalization rate using
overall cost of capital as 15%.
(iii) Compare the results and comme nt on the differences.
[B. Com (H), Dellii Univ., 2019; Simialar question in 2006)

Solution: (i) Value of the Firm anf overall cost of capital as per NI Approa ch r
. Particulars . '
~x ~y ·
. ' -~
.

EBIT ( '4,50,00 0 x 0.20) 90,000 90,000

Less Interest (, 2,00,000 x 0.12) - 24,000

Earnings available for equity-shareholders (NI) • 90,000 66,000

Equity capitalization rate (k.) 15% 15%

'

Market value of Equity (E) = (Nllk.) 6,00,000 4,40,00Q

Market value of Debt (D) - 2,00,000

6,00,000 6,40,000 •
Total value of the form (V) = (E + D)

ko= EBIT 15% 14.06%

V
(ii) Value of the Firm and cost of equity as per NOi Approa ch
t
- . ., .
F -

.. ..· . ·,; -.:--»:

Particular
- . . . ConptnyX. ! - ~•.·1
,. '
{i.j
- . .. ,-
,,: ..

90,000 90,000
err
Less interest - 24,000
90,000 66,000
Earnings available for Equity shareholders (NI) .
ko 15% .. 15%
6,00,000 6,00,000
Market value of firm (V) = (EBIT/k0)
Market value of debt (D) - 2,00,000
6,00,000 4,00,000
Market value of equity (E) = (V - D)
15% 16.50%
Equity capitalisation rate k• = (NI/E)
Approach,
(iii) (a) As per NI Approach, levered firm has higher value and lower cost of capital. As per NOi
total value of the both firm remain s same.
{b) Cost of equity for the unlever ed firm remain s same in both the approac
hes.
e. Firm 'X' has 8%
Illustration 8. Two firms X and Y are identical in all respects except the degree of leverag
res oft 20,00,000. Operati ng profit of both the firms is f 6,00,000 and tax rate is 45%.
F.quity capitalilation
debentu
and cost of ecruty of~' Ltd..
rate of firm 'Y' is 10%. Calculate value of each firm accordi ng to M-M approa ch
Also compute the overall cost of capital. [B. Com(H), ~lhi Univ. 2015,SimO., flllllioll .W in 2013]
 Solation: Valuation u per MM Approach with taxes:
· (EBIT){ l-t)
Value of unlevered firm (Company Y): V11 = k
t

EBIT = , 6,00,000

Hence, V = 6,00,000(1-0.45) =, 33,00,000

II 0.10
Value of levered firm (Company X) V1 = V11 + Dt
= 33,00,000 + 20,00,000 X 0.45 •
'i,
'
= 33,00,000 + 9,00,000 = f 42,00,000
Calculati on of Overall Cost of Capital of X Ltd. using MM Approach :
r
EEIT 6,00,000
Less Interest 1,60,000
EBT 4,40,000
Less Tax (45%) 1,98,000
Earnings for shareholders 2,42,000
Value of the flnn M (As calculated earlier] 42,00,000
Less: Value of debt (D) 20,00,000
Value of Equity (E) 22.00.000 •
k of X Ltd. = ~ fer equity sharerolderes x 100
~ E
= 2,42,00 0 X 100 = llo/o
22,00,00 0
k0 ofX Ltd.= w4 x k4 + wt x kt

-_ 20,00,000 x 4.40¾
o+22,00,00
- - -0x llo¾o {... After tax kd
42,00,()()() 42,00,000
= 8% (1- 0.45) = 4.4%}
= 0.4762 x 0.044 + 0.5238x 0.11 ⇒ 0.02095+ 0.0576= 0.07855 or 7.86%
Note: Overall cost of capital of Y Ltd. (unlevered firm) will be =kt = 10%.
Illustration 9. From the information given below, determine the value of the two firms, X Ltd. and Y......
belonging to homogeneous risk class except in terms of capital structure under (i) Net Income approach 81¥ln.Dl
Net Operating Income Approach.

XUd. ~ .
Earning before interest and tax(EBIT) , 2,25,000 2,25,000
Interest , (0.15) 75,000 0
Equity capitalisation rate 20% 20%
Corporate tax 35% 35%
 Firm as per NI Approach:
tio" (b): (11 Value of the
5ol11 _ . , . ... . ...- .- . . _ ..
•..•~- P9tt1culars •• • • • '
2,25,000 2,25,000
eerr 75,000
LBSS Interest
Earnings available for equity-shareholders (NI) 1,50,000 2.25,000
52,500 78,750
Less: Tax
97,500 1,48,250
EAT 20%
20%
Equity capitalization rate (k.)
4,87,500 7,31,250
Market value of Equity (E) = (Nl/k.)
5,00,000
Market value of Debt (D)
9,87,500 7,31,250
Total value of the finn (V) = (E + D)

(ii1 Value of the Firm as per NOi Approach: NOI Approach is similar to MM A,,,,,-oach.
Henu, MM
Approach with tax assump tion ca'! be applied for calculating the value of the firm.
2,25,000(1- 0.35) , ,3l
EBIT(l- t)
Va1ue of unlevered firm (Y) = = - - - - - - = 7 ,250
kt 0.20
Value of levered firm (X) =Vu+ Dt = 7,31,250 + 5,00,000(0.35) =, 9,06,250
Value of equity of levered firm (X) = t' 9,06,250-5,00,000 =, 4,06,250
kt of levered firm (X Ltd.) = Earnings for equity shareholderes = 97,500 = 24
%
E 4,06,250
k of levered firm (X Ltd.) = wd x kd+ wt x kt
0

= 4 , 06, 250 X 24% + 5,00,{)()0 X 15(1- 0.35)o/o = 16.14 o/o

9,06,250 9,06,250 .
k0 ofYLtd . =20%
debentu res of
Illustration 10. 'L' Ltd. and 'U' Ltd. are identical except that 'L' Ltd. has issued 100/o
f 9,00,000 while 'U' Ltd. has only equity in their capital structure. Both the firms have
operatin g profit of
f 3,00,000. Assume capitalisation rate of 15% for all equity firm.
(i) Compute the value of the two firms using Net Income (NI) approach.
(ii) Compute the value of the two firms using Net Operati ng Income (NOi) approac
h.
[B. Com(H), Delhi Unit,. 2015)

Valuati on as per Net Income Approach

Solution: (i)
'U' Ltd(A/1 equity) .: .. • • LUI( .. ,,
f
.
•~• "•

'~..
'
.,,.,.~- ... ... -
(" ');

~-~
Ill~ •

Particulars ........ :,

3,00,000 3,00,000
EBIT
90,000
Less Interest
3,00,000 2, 10,000
Earnings available for equity shareholders (NI)
15% , 15%
Cost of equity (k.) (given)
20,00,000 14,00,000
Market value of equity (E) = NI / k•
9,00,000
Market value of debt (D) (given)
20,00,000 23,00,000,
Total value of the firm (V) = (E + D)

k _ EBIT 3,00,000 3,00,000 11Ao.

20,00,000 X 100=15% 23,00,000 X 1uu-1..-,_~............

o- V X 100

N-: In NI Approach Value of the firm increases and ~ deaeases with increase in debt.
 (ii)
Valua tion as per Net Opera ting Income Approaclt

U' Ltd(AR equity) • 'l(L td(~

• '
a) EBIT
b) k0 3,00,000
3,00.000
15%
c) Market value of the finn = EBIT/ k0 15%
d) Debt 20,00,000
20,00,000
e) Market value of the equity (c~)20 .oo.oo o 9,00,000
11,00,000
f) Earning before tax (EBIT - I )
3,00,000
2,10,000
EBT
) k• = E 3,00,000 2,10,000
x 100
20,00,000 ,c 100 =15% 11 00 000 100=19
I I
,c
t'
.09%
Note: In NOi Appro ach Value of the firm does not chang e with
increase in debt as k8 increases.
Illust ration 11. Comp anies X and Y are in the same risk class, and are
identical in every respect except that
Comp any X uses debt, while comp any Y does not. The levered firm
has f 9,00,000 debentures, carrying 10%
rate of interest. Both the firms earn 20% opera ting profit on their total
assets of , 15 lakhs. Assume perfect
capita l markets, rational investors and so on; a tax rate of 35% and capita
lisation rate of 15% for an all-equity
comp any. Comp ute:
(r) Value of firms X and Y using Net Income (NI) approach.
(ia) Value of each firm using Net Opera ting Income (NOi) approach.
(iir) Overa ll cost of capital (KJ for firms X and Y.
(iv) Which of these two firms has an optim um capital struct ure using NOi
appro ach and why?
[C.S. Final, June, 2002, B.Com. (H) Dtlhi Unit1. 2012)
Solution: Impor tant Note: NI and NOi Approaches assum e no corpo
rate taxes. However, questions are
asked in examinations where corporate tax rate is given and stude nts
are expected to incorporate effect of tax
in these appro aches . 1bis questi on has been solved after incorporatin
g the tax effect in these approaches.
(i) Value of firms X and Y using Net Incom e (NI) appro
ach.

.. - ·--~
•-·· • T:J

20
EBIT (15,00,000 x
100 ) 3,00,000 3,00,000

EBT
Less Interest
90,000
2, 10.000 3,00,000
-
Less Tax (35%)
73,500 1,05,000_
Earnings available for shareholders (NI)
1,36,500 1,95,000_
Cost of equity (k.J 15% 15%
NI
Market value of equity (E) = k 9, 10,000 13,00,000
•
Market value of debts (D) (given)
Total value of the firm M = (E + D)
9,00,0 00
18,10,000
-
(ii) Calcu lation of value of firm as per NOi appro ach (MM
Appro ach with taxes)
Value of unlev ered firm (Y Ltd) = EBIT t- t) = 3,00 ,~~-0.35 ) = '13,00
,000
Value of levere d firm (X Ltd) =Vu + Dt ⇒ 13,00,000 + 9,00,000 x 0.35
= 13,00,000 + 3,15,000 = , 16,15,000
 -------
(iii) (a) ko as per NI appr oach :

fXL td.=k ><W e+kj 1-t)x w4]= 15% x 9,10,000 +100/4(1-0.35)x 9,00,000
18,10,000
k0 ° t'
18,10,000
= 7.54°/4 + 3.23% = 10.77%
k ofY Ltd.= kt= 15%
0
NOVMM Approach:
(b) Calculation of Overall Cost of Capital of X Ltd. using
Value of the firm (V) (As calculated in part (ii) of
the question) '
16,15,000
9,00,000
Less Value of debt (D)
7,15,000
Value of Equity (E)

_ Earnings for equity shareholderes 1,36,500

kt of X. Ltd • - E - 7,15,000 = 0.1909 = 19.09%

7 15 000 + 100/o(l-0.35) x 9' 00' 000

t) x w = 19.09% x ' '
k of X Ltd.= kt x wt+ ki1 - 4 ]
16,15,000 , 16,15,000
0
= 8.45% + 3.62% = 12.07%
ach.
(it1) When tax effect is incor pora ted in NOi
approach then it no longer remains an iJrelevance appro
oft 16,15 ,000
structure, because it has high er value
Hence, company X (levered firm) has optim um capital •. ;: ~
vered firm) oft 13,00,000 and k0 of 15%.
and lower k 0 of 12.07% as again st valu e of Y Ltd. (unle
other except that S Ltd. has debt of t 4,00,000 at the
Illustration 12. Two companies are identical to each
ture. The total assets of both the company amounts
rate of 8% whereas R Ltd. has no debt in its capital struc et
to f 25,00,000 on which comp any earn s 20%. Find
the following if both the companies are in the tax brack
of 40%.
using NI appr oach assuming kt as 15%.
(a) Value and overall cost of capital of the companies
(b) Value of the companies using NOi appr oach
taking kt of R. Ltd. (Unlevered firm) as 15%.
NOi / MM approach.
(c) Overall cost of capital of S. Ltd. (Levered firm) using

Solution: (a) Valu e of the Com panie s as per NI Approach

•·
. .. .. ..
~ , . Particulars
~

•• ·• • ., . . •• :-•·--~/·:
..

5,00,000 ..
1~~ = f 5,00,000)
5,00,000
EBIT (25,00,000 x
32,000
Less Interest
4,68,000 5,00,000
EBT 2,00,000
1,87,200
Less Tax (40%)
PAT 2,80,800
15% •
Cost of equity (k.J
Value of equity (E) = PAT 18,72,000
k•
Value of debt (D)
4,00,000
22,72,000
Total value (V) = (E + D)
= k• x w• + kJ.1 -t) x we,) 13.2 0"
Overa11 cost of capital (k0)

18,72,000 4,00,000
Note:k ofS
o Ltd. = 15% x 22, 72, 000 + 8% (1-0. 40) >< 22,?l,OOO
 (b) Calculation of value as per NOi approach (MM Approach with taxes)

Value of unlevered firm (R Ltd) = EBIT (l - t) = S,OO,CXX)(l - 0.40) = f 20,00,000

kt 15%
Value of levered firm (S Ltd) =Vu+ Dt ⇒ 20,00,000 + 4,00,000(0.40) = f 21,60,000
(c) Calculation of Overall Cost of Capital of S Ltd. using NOi/MM Approach: t
Value of the firm (V) [As calculated In part b of the question] 21,60,000
Less Value of debt (D) 4,00,000
Value of Equity (E) 17,60,000

k of S. Ltd.= Earnings for equity shareholderes = 2,80,800 = 0_1595 = 15_95%

e E 17,60,000
7 4
k0 of S. Ltd. = kt x wt+ kll - t) x wdJ = 15.95% x t ,60,000 + 8%(1-0.4)x ,00,<XX)
21,60,000 21,60,CXX)
~ 15.95 %x 0.8148 + 4.8 %x 0.1852 ⇒ 13% + 0.89 % ⇒ 13.89%
Illustration 13. Following is the data regarding two companies A and B.

• CompanyA

Number of ordinary shares 80,000 1,20,000

Market price per share , 1.10 1.00
8% Debentures , 50,000
Profit before Interest , 15,000 15,000
Entire profit after interest was distributed as dividend.

All profits after debenture interest are distributed as dividend. Explain using the MM approach, how an
investor holding 12.5% of shares in company A will be better off in switching his holding to company 8.
[B.Com(H), Delhi Univ.2017)
Solutfon: r
Particulars Company A

BIT 15,000 15,000

• Less Interest 4,000
Earnings available for equity shareholders 11,000 15,000

Assuming 100°/o payout, Company A will distribute, 11,000 as dividend to its shareholders whereas company
B will distribute , 15,000 to its shareholders
Now, we will see whether the investor would be benefitted by selling his shares in Company A and
buying shares of Company B. •
Suppose an investor sells 12.5% of his holding (10,000 shares) in Company A, then he will realize' 11,(XM)
(10,000 x 1.10). He takes a loan at @ 8% of f 6,250 (125% of fS0,000) and out of the total cash of ' 17;81
(f 11,000+f 6,250), he purchases 12.5% of shares of Company B i.e. 15,000 shares for ,1sooo (15000>< 1.00).
Position of Investor in Company A (Before switching over to Company B) ,
(a) Investment Value [12.5% of , 88,000(80,000 x 1.10)) 11,000
(b) Dividend received (12.5% of , 11,000)
 Position of Investor in Company B <After •witching over &om Company A)
Fund available [11,000 + 6,250 (12.5% of , 50,000)] , 17,250
~: investment made (Purchase of 12.5% equltyholdlng) 15,000 ..
(c) Net income:
Dividend Income (12.5% of ,1s,OOO) 1,875
Less Interest payable (8% on , 6,250) 500 1,375
(d} surplus funds available (or reduction in outlay) for Investment elsewhere :
(, 17,250 - , 15,000) =, 2,250
Therefore, by shifting from company A to company B, he will earn same income of , 1,375. But he is
having, 2,250 (17,250-15,000) surplus cash with him to invest elsewhere. Hence, investor will be better off in
switching his holding to company B.
Illustration 14. "The value of a firm is independent of the proportion of debt to total capjtaHution. The
arbitrage process will esta?lis~ a m~rket e~uilibri~ in which the to~l value of the firm will depend only on
investor's estimate of the firms business nsk, and its expected future income."
Explain the above mentioned statement with the help of the following data regarding two companies A and B,
with the same expected annual income and same risk class.
. , J
'~,. ......,~
• •. VariableS CompanyA . . .. : Compan,-lt :~~
• -y:~ ,"";,;;,\ .....

Expected annual income (Y) , 30,000 ,30,000

Market value of debt (D) - , 1,20,000 .
Rate of interest on debt (i) - 0.125
'
Required rate of return on equity (K) 0.15 0.16
Market value of Equity (E) , 2,00,000 , 93,750
Market value of company (V), (V = D + E) , 2,00,000 , 2,13,750

Show your workings in relation to an investor who holds 10% of the outstanding shares of the
levered company B. [BBS (H), Delhi Univ. 2011]
Solution
·. . . •. . . . • .. • . . ;_;'J
.. ' . CompanyA r: . ; Cotnpan,
. .
·lir.".•·.·.:-:<,.-.,

EBIT 30,000 30,000

Less Interest (12.5% on r 1,20,000) - 15,000
Net profit (NI) 30,000 15,000

Required rate of return on equity (k.) 0.15 0.16

NI
Value of equity (E) = k 2,00,000 93,750
e
I
Value of debt (D) = kd (given) 1,20,000
Total value (V) = E + D 2,00,000 2,13,750

WACC, (ko) = EBIT 15% 14.03%

• . V

of.;! :in investor holds 10% equity share capital of company B (over-valued firm)
of, 11\Vestment will be 10% of, 93,750 i.e. , 9,375. Assuming 100% payout then n11111
15,000 of company B, he is entitled for , 1,500 as his share of profit. He Is
 16% [i.e. (l,500/9,375) x 100) on his investment value. Now, he wants to increase his earning, BO he
decides to shift his holdings from company B (overvalued) to company A (undervalued). He d ~
off his holdings in company Bfor, 9,375. But to buy 10% shares of company A (i.e.100/o of 2,00,000) he
takes personal [email protected]% p.a. of, 12,000 (i.e. an amount equal to 10% of the debt of thecompanyB).
As an investor of company B, he is comfortable with debt level of company B, so his risk level will not
alter after this borrowing. Only difference now is the position of the investor is levered because he has
created a personal leverage (homemade leverage) by borrowi ng, 12,000 from the market. Infact,he
has replaced the corporate leverage of company Bwith his personal leveage at the same rate of interest
keeping his overall risk level intact. Now, he is having total funds of, 21,375 (9,375 + 12,000). He
invests , 20,000 to buy 10% shareholding in company A and still left with , 1,375. Assuming that
company A continues to earn same EBIT off 30,000, net return available to him from his new investment
outlet i.e. company A are as follows :
Net return (')
Profit available from company A (10% off 30,000) 3,000
Less interest payable (12.5% on 12,000) 1,500
1,500
The investor is getting same return off 1,500 from company A too, which he was receiving asan
investor of company B. However, he has, 1,375 left with him for invesbnent elsewhere. Thus, his total
income may now be more than , 1,500 (includi ng some income on the investment of
, 1375). This analysis can be summarized in the following table :
I
I
I
I
,,I Effect ofArbitrage
1 1. Investor's existing position in Comapny B (levered firm) with 10% equity-holding:
'
I
I

(a) Investment Value (10% of, 93,750)

(b) Dividend income (10% oft 15,000)
'
9,375
1,500
2. Total funds available with investor before swapping from Comapny B to Comapny A:
(a) Own funds t 9,375
(b) Borrowed fund (10% of, 1,20,000) 12,000 21,375
3. Investor's position in Comapny A after swapping from Comapny B :
(a) Investment made (purchase of 10% equityholding) 20,000
(b) Net Income:
Dividend income (10% of, 30,000) 3,000
Less Interest payable (12.5% on , 12,000) 1,500 1,500
(c) Surplus funds available (or reduction in outlay) for investment elsewhere 1,375
c, 21,375 - , 20,000)

The above analysis shows that an investor can earn more income if he invests funds in ComapnY
A (under valued firm). Other investors will follow the same process and buying demand will jnO'ed!
the share price of Comapny A. On the other hand, due to selling pressure, share price of the eomapl'J
B (over valued firm) will decline. This process will continue as long as it is possible to reduce the
invesbnent amount and get the same return. Beyond this point, it will not be possible for the in
to get the extra benefits from any of the firm. This is known as equilibrium point. This is the
 e of the two firms as well as their overall cost of the capital would be same. This
total valu d'
where ·s known as arbitrage process So, accor mg to the MM hypothesis, due to arbitrage process,
1
process fa levered firm cannot be more than that of an unlevered firm and the reverse is also
total va1ue o th . ·11 .
the Jtimately the total value of e firm w1 depend only on investor's estimate of the firm's
ttence, u .
trUt• . k, d its expected future income.
business _ns ;nThere are two firms A Ltd. and B Ltd. which are identical in all respect except in terms of th~
1
"ctu;e
111ustr0 h 0
capital strU
as can be observed from the details given below:
•
Particulars • · ', • - •• • • • /~:4~:;-~>}ift:l:~fil;: lfJ:};:im;~~:.£:!i.L:tt1:rY ;, .-: ·_-
EBrT ,1,00,000 ,1,00,000
10% Debentures ,s,00,000
k, 16% 12.5%

Calculate the value of the two firms and illustrate using the MM approach, how an investor holding 10 °/o of
hares of A Ltd. will be benefited by switching over his investment from A Ltd. to B Ltd. When will the
:rbitrage process come to an end? [B. Com (H), De!~i Univ., 2018]
Solution: Value of firms:

EBIT 1,00,000 1,00,000

Less Interest (10% on f 5,00,000) 50,000
Net Income (NI) 50,000 1,00,000

Required rate of return on equity (k8) 0.16 • 0.125

NI
Value of equity (E) = ke 3, 12,500 ,., 8,00,000

I
Value of debt (D) = kd (given) 5,00,000 -
Total value (V) = E + D 8, 12,500 8,00,000

WACC, (ko) = EBIT 12.31% 12.5%

V
~wning 100% payout, A Ltd. will distribute , 50,000 as dividend to its shareholders whereas B Ltd. will
N tribute f _1,00,000 to its shareholders. •
°:'i~e
of will see whether the investor would be benefitted by selling his shares in A Ltd, and buying shares

Position of Investorm
• A Ltd. (Before switching over to B Ltd.): '
(a) Investment Value (10% of , 3 12 500) 31,250
(b) . . , ,
Pos·ti Dividend received (10% of ,so,OOO) 5,000
, on of Investo • B
(a) F r in Ltd. (After switching over from A Ltd.):
(b) Inund available [31,250 + 50,000 (Debt:10% of ,s,00,000)) 81,250
80,000
(c) Nveslnctinent made (Purchase of 10 % of equity~holding)
et ome:
Di • 10,000
Lesvidend income (10% of fl,00,000)
s: Interest payable (10% on , 50,000) 5,000
5,000.
(d) Surplu s funds availab le (or reduct ion in outlay) for invesbnent elsewhere
.
( ' 81,250 - , 80,000) = '1,250 •
Theref ore, by shiftin g from A Ltd t B L d . •
'l~tchin(Slhis~h - ~0,000) surplu s ca;h°with ~~~ :!~a~: ereinH encom e
sw1 g olcling to B Ltd. o_f' 5,000. But he ia
• ce, mvestor will be better
~trag e ~ will ':'°'11e to_ an end when market price of the shares of both
the firms
( ) Why 1S consid eration of time value of money import ant • fin •al d .
adjuste d? m ana
. becomes equal.
eas1on making? How can tune.:
Illustration 16. The marke t values , earnin gs and other information of u Ltd
. d Ltd .
• • an • are given be-.
U. Ltd. f
Equity
60,000 30,000
Debt
Total Value 25,000
60,000 55,000
Earning
9,000 9,000
0
Less Interest (8% on r 25,000)
2,000
Net profit
9,000 7,000
Equity capitalization rate (keJ (NP/Equity) 15% 23.3%
kd
ko 8%
15% 16.4%

Show how an investe r holdin g 10% equity in U.Ltd can be benifited by employ
ing an arbitrageproaa
Solution: Thoug h, both the U. Ltd. and L. Ltd. have same earnin g of, 9,000
but still U. Ltd. has
marke t value (Y) and lower k as compa red to L. Ltd.. Since value of unleve
0 red firm. is more than the
firm then arbitrage proces s in the reverse directi on will set in and this will bring
the market values of
firms equal. The invest or holdin g 10% equity in U.Ltd (unlev ered and overva
lued firm) will dispoee
holdin gs and acquir e same propor tion (10%)of equity and debts of L.Ltd.(
levered and undervalued
This will give him same return s for a lower investm ent outlay.The surplu s funds
can be investede,t~m111111
earn extra return s. The effect of arbitra ge proces s in the reverse direction is
shown in the following table·
Effect of Reverse Arbitrage
1. Investor's existing position in U.Ltd. (unlevered firm) with 10% equity-h
olding:
(a) Investment Value(10% of ,oo,000)
(b) Dividend income (10% of t9,000)
2. Total funds available with investors before swapping from U.Ltd. to L.Ltd.:
(Own funds, 6,000 from selling of equity holding in U.Ltd)
3. Investor's position in L.Ltd.after swapping from U.Ltd. :
(a) Investment made (purchase of 10% equityholding and debts)
Equity (10°/4 of t30,000) 3,000
Debts (10% on t25,000) 2,500
(b) Net Income:
Dividend income (10°/4 of ,1,000) 700
Interest Income (8% on t2,500) 200
(c) Surplus funds available (or reduction in outlay) for investment elsewh
ere
( f 6,000 - fS,500)
 --------------------------~--
by shifting from U.Ltd. to L.Ltd., he will earn same income off 900. But he is having f 500
~,500) surplus cash with him to invest elsewhere.Hence, he is benifited.
( tion 11. The following information is available for Y Ltd. and Z Ltd. Compute the equilibrium
lllflSt,a(V) and equity capitalization rate of the two companies assuming (r) there is no income tax (ii' the
. . ra te 1s
values capitalization . 120¾ ,,
o.
over:all

1,20,000 1,20,000
eerr
Less Interest 8% 20,000
1,00,000
-
1,20,000
Net Income for equity shareholders
Equity capitalization rate (k8) 15% 14%
Market value of equity (E) 6,66,667 8,57, 143
Market value of debt (D) 2,50,000
Total market value (V) = (E + D) 9, 16,667 8,57, 143
EBIT
Cost of capital (k0) = ~ 13.09% 14%

Solution: To find out the equilibrium values of both the firms, EBIT should be capitalised at k0 and then
divided between debt and equity • t
•·-· ·• ·.. Particulars

BIT 1,20,000 1,20,000

Overall capitalization rate (k0 ) 12% 12%

Total value of the firm (V) = E:IT (Equilibrium values) 10,00,000 10,00,000
0

Market value of debt (D) 2,50,000 •

Market value of equity (E) = (V - D) 7,50,000 10,00,000
Earnings for equity shareholders (given) 1,00,000 1,20,000
k•(Y Ltd.)= 1,00,000 13.33%
7,50,000
k.(z Ltd.)= 1•20,000 12%
10.00.000

Firm Y Ltd. having debt in its capital structure has higher kt equal to 13.33%.
Illustration 18. The two companies U and L belong to the same risk class. They have everything in common
except that firm L has 12% debentures of '10,00,000. The following information about the two firms is available
to you:

Particulars Firm U Firm L

Net operating income (EBIT) , 4,00,000 , 4,00,000
12% Debentures , 10,00,000
Equity capitalization rate (kJ 0.15 0.16
~cula~ the value of two firms and explain how under Modigliani - Miller approach an investor wm. . -
w~eqwo/ shares of the overvalued firm will be better off switching his holdings to the other firm. Allo~
arbitrage process will come to an end.
[B. Com (H), Delhi Univ. 2020, simwir qwstion, bl~
 ·~-. . , . , ~....... ~ · - - - ' - ~ ~ -,.,-- • · • • •. 7 •r
.... • .. .,.,""~-,.....,,. .-...-.....-..,.. · ~ - . . - ; - ...

7.36 nanclal Management -

, , . , , ......_.,,.._. ..J'"'--""A- ......-# ~••...-.. .~-
•;- • . . . . . . : - . ~•• •..,·.,:..:_.,,,. ,.~ ....• - ~ _

Solut ion:
Firm U (t')
Particulars
4,00,000
Net opera ting Incom e (EBIT)
Less Interest on debt (I)
4,00,0 00
Earnin gs to equity shareholders (NI) 0.15
Equity capitalization rate (k.)
26,66, 667 17,50,000
Marke t value of equity (E) = ~
k• 10,00,000
Marke t value of debt (D)
26,66,667 27,50,000
Total value of firm (V) = (E + D)

(Presently over- value d firm):

Solut ion: (1) Current positi on of inves tor in comp any L Ltd.
00
Investor's holdi ng in Comp any L = 10% off 17,50,000 = f 1,75,0
Share of earnin gs in Comp any L = 10% of f 2,80,000 = f 28,000

Steps for Arbit rage Process:

of r 26,66 ,667) inves tors will have to borrow
In order to have the 10% holdi ng in comp any U Ltd.(i.e. 10% •
st i.e., 12%
l' 1,00,000 (10% of debts off 10,00,000) at same rate of intere
r
Now he will have : 1,75,000
Own funds (by selling his holdi ng in firm L) 1,00,000
Borro wed funds (at 10% rate of interest)
2,75,000
Total funds
(Pres ently under -valu ed firm):
Posit ion of inves tor after shifti ng from firm L Ltd. to U Ltd.
for f 2,67,667 (10%-hoJding).
With f 2,75,000 in his hand, he will buy share s in Comp any U
40,000
His share of earnin gs in Comp any U (10% of r 4,00,000)
12,000
Less Intere st on borro wings (12% of r 1,00,000)
28,000

U (unlev ered) he wi!l earn the same income

By shifti ng his holdin gs from comp any L (levered) to comp any
8,333 to be inves ted elsew here.
off 28,000. But at the same time he will have surpl us funds of~
Hence , reduc tion in outla y= (f 2,75,000- f 2,66,667) = f 8,333
(it) Arbitrage process will come to an end when marke t price
of the share s of both the finns become equal.

X is unJev ered, while y has 3,00,000 of 61'

Illust ration 19. Firm X and Y are simila r excep t that firm
ting incom e (EBm at f 50,000 and the cost of
de~t ures outsta nding . Assuming tax rate at 50%, net opera
ption s are met. (ii) If the value of thefiJ'III
eq_wty at 10% (z)calruJate ~eva lueof both the firm, if the MM assum
how will equili brium be reach ed 7
Y IS "4,20,000, then do th1S repres ent equili brium value? If not
Solut ion:

(1) Value of unJevered firm (X Ltd.): V = EBIT(l - t) =

SO,CXX> (l-0.5 0) = f 2,so OO0
' u kr 100/o
Value of levered firm (Y Ltd.): v, = Vu + Dt
= 2,50,000 + 3,00,000 (0.50)
= 2,50,000 + 1,50,000 = f 4,00,000
 To brin ·
f 4,20,000, so it is ove rval ued by, 20,000.
firJJl y is, 4,00,000 whe reas it is giv en as r g
ri1J JJ1 , arbi trag e pro cess will be foll owed:
(hJ V'~
4,20,000
~ tlae f the firm (Y) (given) 3,00,000
f,J ~ Value of deb t
1,20,000
f,Jue of equity 00
50,0
18,000 •
BBrfUSS Interest
32,000
Fil'USS Taxes (500/o) 16,000
16,000
PAT/EAT
Han investor has 10% of Y Ltd .'s sha res then
(i) His holding is 10% of 1,20,000
= , 12,000
(i,) His return are 10% of 16,000 =
f 1,600
sha res of X Ltd. He
investor can get sam e earn ing s by sell ing his hol din g in firm Y and pur cha sing 00onhispersonal
This i.e. , 15,0
. and bor row ((10% of 3,00,000) (1- t)]
wouldsellhisholding for f 12,000 in Y Ltd hav ing f 27,000 (f 12,000 + 15,000) at his
h is his perc enta ge hol din g in Y's deb t. He is now
acxount whic ,000) i.e. firm X's sha res for f 25,000
dispoSal Now he will pur cha se (10% of f 2,50
His retu rn would be as follows:
swi tch ing over to Firm X)
Pos itio n of Inv esto r in Fin n Y (Before , 12,000
)
(1) Investment Value (10% of t 1,20,000 f 1,600
(b) Dividend received (10% oft 16,000)
swit chin g over from Firm Y)
Posi tion of Inve stor in Firm X(After • •
, 25,000
equityholding)
(1) Investment made (Purchase of 10%
(b) Net Income:
2,50 0
Dividend income [10% of t50,000(1-t)] 900 ,1,6 00
Less Interest payable (6% on ?15,000)
f 2,000
in outlay) for investment elsewhere
(c) Surplus fundsavailable (or reduction
( ' 27,000 - ?25,000) same returns of
' 27,~00 at his disp osa l. He has inve sted f 25,000 in firm X and is earning
, 1~ ha~ be inve sted elsewhere.
•He 15 having , 2,000 as left ove r fun ds to . .
d whi le L has
2 eve ry resp ect exc ept that U 1s unle vere
lll11Sfrati l in
f 20 on O. Companies U and L are iden tica for U is 10%.
8 deb t EBIT of bot h firm s is 6 lakh and tax rate is 35%. Equity capitalisation rate
Ca th l~ of %
App roa ch and cos t of equ ity for L Ltd .
te e value of eac h firm acc ord ing to MM (B.Com (H) Del hi Uni v. 2006)

Sol•tion: roac h (wit h taxes)

Val ue of the Firm as per MM App
.. •• . . Compeny.U ·: .
Unlevered firm (fJ
EBIT 6,00,000
te.. 1ntereat
E8r 6,00,000
LeaataxQ35% 2, 10,000

-•ti bia for equity shareholders (NI) 3.90.000

 0,000
s V = (EBIT)(t-t) = 3,90,000 = f 39,0
Val ue of Unl eve red firm CU) wit h taxe k, 0.10
3 all equity finn)
k0 of unl eve red firm = NI = 39,0, 90,000 = 0.10 or 10% (No te: k0 = kt for
E 0,000
Val ue of levered firm (L) with taxes: 0
v, = V" + Dt ⇒ 39,00,000 + 20,00,000 x 0.35 = f 46,00,00
firm :
Market valu e of equ ity (E) for levered
E = V - D ⇒ 46,00,000 - 20,00,000
= f 26,00,000
Earnings avai labl e to equ ity Sha reho
lder s _ 2,86,000
.
E - 26,00, 000 = 0.11 or 11~
k e o f Ievered f1rm =
of levered firm: k0 = k, (1- t) x w, + kt
x w,
Weighted Average cost of capital (k0 )
20,oo,ooo 26' 001000 0.0226 + 0.0622 = 0.0848 or 8.48%
- - + 0.11 x __,;__ _ =
= 0.08 (1 - 0.35) x - 46,00,000 46,0 0,00 0
12,00,000 at an average
stra tion 21. SR Ltd. has EBI T off 3,00,000. The firm has an out stan din g deb t off
Illu
estimated to be 15%.
cos t of 10% and the cos t of equ ity (k) is atio n approach.
(1) Det erm ine the cur ren t vaJue
of the firm usin g the trad itio nal valu
(it) Determine the overall capitalizati
on rate, k0 •
a,st~
ring to issu e cap ital off 4,00 ,000 in ord er to red eem f 4,00,000 debt. The
(iii) The firm is con side be 13% due to
eve r, the firm 's cos t of equ ity capital ,vill
deb t is expected to be unaffected. How
this pro pos al?
decline in leverage. Do you reco mm end
firm as per trad itio nal app roa ch
r
Val ue of the
Sol utio n:
3,00,000
(I) EBT 1,20,000
Les s Interest 1,80,000
lders
Earnings available for equity shareho 15%
Equity capitalisation rate (k.)
12,00,000
Market value of equity (E) = NI
ke
12,00,000
Market value of debt (D) 24,00,000
Total market value of firm (V) = (E + D)

(ii' kO = EBIT = 3,00,000 = 12 So/c0

V 24,00,000 •
'I
r
(iii) Effect of Red emp tion of Deb t
3,00,000
SIT 80,000
•Les s Interest (10% on 8,00,000) 2,20,000
Netfncome 13%
Equity capftalisation rate (k.)
2 16,92,308
Market value of equity (E) = ·!~~~oo
8,00,000
Mar ket value of debt (0)
24,92,308
Total market value of firm (V) = (E + D)

k0 - !!!! -- 3,00,000
24,92,308
12.03%
- V
24,00,000 to f 2
The !:r .n ~I ;ho ~d ~ acce
firm from f
pted as it wou ld increase the valu e of the
% to 12.03%.
cos o capital IS also red uce d from 12.5