This document discusses capital structure and leverage. It defines capital structure as the mix of long-term financing sources like equity shares, preference shares, debentures, and long-term debt. It notes that the optimal capital structure maximizes shareholder wealth while minimizing costs. Leverage refers to using fixed costs to magnify returns - operating leverage uses fixed operating costs while financial leverage uses fixed financing costs. The document provides formulas for calculating operating, financial, and combined leverage and gives examples of how to compute them based on information about sales, costs, debt, and earnings.

1. CAPITAL
STRUCTURE

2. FINANCIAL MANAGEMENT
FUNCTIONS
FINANCING
SOURCES
CAPITAL STRUCTURE
LEVERAGE
COST OF CAPITAL
INVESTING
CAPITAL BUDGETING
WORKING CAPITAL
DIVIDEND
DIVIDEND POLICY
DIVIDEND THEORY

3. CAPITAL STRUCTURE
• Finance Mix of the different sources so as to maximise the wealth of shareholders
• It is a mix of various sources from where long term funds required for the firm are
raised
• Ratio of equity shares, preference shares, loans, debentures, internal sources
“It is the composition of long term sources of funds such as debentures, long term debt,
preference share capital and ordinary capital including reserves and surplus” I.M.Pandey
“ It is the combination of debt and equity securities that comprise a firms financing of its
assets”- John. J.Hampton

4. IT INCLUDES THE FOLLOWING
DECISIONS
Capital
Structure
Type of
securities
Shares
Debt
Ratio/Propotion
of securities
The decision of capital structure is called Capital Gearing
Low geared- if equity shares proportion is high
High- if its vice versa
If its equal – evenly geared

5. PATTERNS OF CAPITAL STRUCTURE
Equity shares
only
Equity shares and
preference shares and
long term debt
Equity shares
and
preference
shares
Equity shares and long
term debt

6. FINANCIAL STRUCTURE?????
• Liability side of the balance sheet shows financial structure
• Both long term and short term sources of finance included
• Capital structure is a part of financial structure covers permanent financing including
shares and debt excluding short term credit
OPTIMUM CAPITAL STRUCTURE: when the firm has chosen the combination of equity
and debt such that the wealth of shareholders is maximum
Cost of capital is minimum
Market price of share is maximum
(in practical only appropriate capital structure is possible

7. FACTORS DETERMINE CAPITAL
STRUCTURE• Trading on equity :
Taking the advantage of equity i.e. owners fund to earn profits
If rate of return is high than cost of borrowed fund i.e. preference shares/debts then the
firm shall arrange more funds from these sources so as to earn more profit after paying
fixed rate from these sources
Capital Structure A ltd B Ltd
Equity 40 lakh 8 Lakh
15% debentures 8 lakh 40 lakh
Gross Income 9.2 lakh 9.2 lakh
- Int on debentures 1.2 lakh 6.0 lakh
Net earnings 8 lakh 3.2 lakh
Earnings From shares Net earnings/Equity capital
*100
8/40*100 = 20% 3.20/8 *100 =40%

8. The additional earnings due to borrowing more of fixed interest funds is called trading
on equity
Higher dividend for shareholders, company can retain profit
If earning are lower than fixed rate carried by debt funds
• Stability of Sales:
Only if there is higher or stable sales the company can make profit
Only then pay for debentures as it is to paid irrespective of profit.
So too much debt not suitable
• Exercise Control :
Control remains with directors elected by shareholders
If control needn’t be shared then equity shares shouldn’t be the focus but debt and
preference shares

9. • Cost of Capital
payment paid to obtain capital
Interest and dividend is the cost
dividend on preference shares is low and fixed
Int on debentures is low so companies prefer debt subject to its earning capacity
• Statutory Requirements
Law regulation should also be considered. Banking companies are prohibited from
issuing any type of security
• Capital Market Conditions
If its depression- equity shares will not have so much demand/ debentures ,preference
shares will be preferred
If its boom- opposite

10. • Corporate Taxation
Dividend on shares- not deductible under tax
Int on debentures- Deductible
Cost of issue of shares deductible all these needs to be considered while choosing the
source
• Government Policies
Rules of SEBI/change in lending policies of financial institutions/taxation
policies/monetary policies
• Flexibility
Whether management able to adjust to unexpected and expected changes in the
business environment.
• Timing:
Proper timing helps to bring substantial savings due to the dynamic nature of stock
exchange
• Size of the firm:
Small firms heavily rely on owners fund and large firms go for debt instruments or
securities

11. • Purpose of financing :
If its for productive purposes like manufacturing etc then raise funds for long term
If non-productive purposes like welfare of employees- internal sources
• Period of financing:
Medium and long term periods – 8 to 10 years then borrowed funds
If funds are for permanent requirement then issue equity shares
• Flotation Costs:
Cost related to issue of shares, debentures. Cost of raising debt is less than cost of
issuing equity shares
• Requirement of investor:
Different types of securities are issued to different class of investors according to their
requirement by giving them options and additional advantages
• Provision for future growth:
Future growth aspects and future capital requirements should be considered

12. LEVERAGE

13. • Firms ability to use fixed costs assets and funds to magnify the return
• Leverage is the employment of an asset or funds for which the firm pays a fixed cost –
James Horne
• No leverage- if firm not required to pay fixed cost
• Fixed cost is something which has to be paid irrespective of the volume of production
or sales and it has considerable effect on the firms profit which is available to
shareholders
Leverage
Operating
leverage
Financial
Leverage
Combined
Leverage

14. OPERATING
LEVERAGE

15. OPERATING LEVERAGE
• Use of fixed cost in the operation of the firm
• Irrespective of volume of sales firm has to bear fixed cost
• It remains constant
• A small change in sales will bring a proportionate change in operating profit-
operating leverage
• It’s the firms ability to use fixed operating cost to magnify the effect of changes in
sales pm its earning before interest and tax
• OL= Contribution/EBIT

16. Particulars Per unit Total
Sales
- Variable cost
a)Direct Labour
b)Direct Expense
c)Variable factory overhead
d)Variable administrative overhead
e)Variable Selling and distribution expenses
Contribution
- Fixed cost
Operating Profit (EBIT)

17. OL can be favourable or unfavourable
Favourable- contribution exceeds fixed cost
Unfavourable –opposite
Problem 1:
Output 20000 units
Selling price per unit Rs.12
Direct materials per unit Rs.5
Direct Labour per unit Rs.2
Variable overhears per unit Rs.1
Fixed cost per year Rs.60000

18. QUESTIONS??
• A firm sells its only product at Rs.12 per unit . Its variable cost is Rs 8 per unit.Present
sales are 1000 units. Calculate the operating leverage in each of the following
a) Fixed cost is 1000 Rs
b) Fixed cost is 1200 Rs
c) Fixed cost is 1500 Rs
Observe how fixed cost is related to operating leverage

19. • Calculate Operating leverage for Maruti Ltd, from the following information
No of units produced 50,000
Selling price per unit Rs 50
Variable cost per unit Rs 20
Fixed cost per unit at current level of sales is Rs 15. What will be the new operating
leverage if the variable cost is Rs 30/unit
The installed capacity of a factory is 600 units. Actual capacity used is 400 units. Selling
price per unit is Rs 10, variable cost Rs 6/per unit. Calculate operating leverage in each of
the three situations
Fixed cost is Rs 400
Fixed cost 1000 Rs
Fixed cost Rs 1200

20. • No of units produced and sold :30,000
Selling price per unit Rs 20
Variable cost per unit Rs 10
Fixed cost per unit at current level of Sales is Rs 5 /unit. What will be the new operating
leverage if variable cost is Rs12
Determine operating leverage
Company A
Sales 50,00,000Rs
Fixed cost 15,00,000Rs
Variable cost 50% of sales
Company B
Sales 60,00,000Rs
Fixed cost 30,00,000Rs
Variable cost 25% of sales

21. • Find operating leverage
Sales 50,000 Rs
Variable cost 60%
Fixed cost 12,000 Rs

22. • Degree of Leverage:
Percentage change in operating profit resulting from percentage change in sales
DOL= % change in EBIT / %change in sales
Higher operating leverage for the firm which uses greater amount of fixed cost and
smaller amount of variable cost
Opposite gives lower operating leverage
X ltd sells 1000 units @ 20 per unit. The cost of production is Rs 14 per unit. The firm has
a fixed cost of Rs 1000. Assume that the sales of X ltd increased by 10%
Find the DOL

23. Find degree of leverage :
EBIT (2008) – Rs 50,000
Sales (2008) – 20,000 units
EBIT (2009) –Rs 60,000
Sales (2009) -28,000 units
Find DOL
EBIT(2005) – 40,000/-
Sales (2005)- 20,000 units
EBIT(2006)- 50,000
Sales (2006)- 28000 units

24. The firm will have no operating leverage if it doesn’t have fixed cost
Consider the following:
Solve and Analyse:
Present Expected
Sales
- Variable cost
20,000
14,000
30,000
21,000
EBIT/Profit 6000 9000

25. FINANCIAL LEVERAGE
• When the firm uses fixed interest /dividend bearing securities i.e. debentures and
preference shares’
• Along with owners equity to improve return
• These fixed financial charges do not vary with operating profit
• They are paid regardless of the amount of EBIT
• What is remaining after paying the fixed charges is paid to equity shareholders
• EBIT/EBT
• “ability of a firm to use fixed financial charges to magnify the effect of changes in EBIT
on the firms earning per share”

26. X Ltd Y Ltd
Equity share capital of Rs 10 each 8,000,000 3,00,000
12% debentures 50,000 5,50,000
Capital Employed 8,50,000 8,50,000
EBIT 2,55,000 2,55,000
EBIT 2,55,000 2,55,000
- Interest on debentures 6000 66,000
EBT 2,49,000 1,89,000
- Tax @ 35% 87,150 66,150
EAT 1,61,850 1,22,850
EPS= EAT/No of Equity shares 1,61,850/80,00
0
=2.02
1,22,850/30,00
0
=4.095

27. QUESTION???
• Buddha Belly Ltd has a choice of the following three financial plans
You are requested to ascertain the financial leverage in each case and interpret it.
Plan 1 Plan 2 Plan3
Equity share
capital
6 lakh 5 lakh 2 lakh
10% Debentures 4 lakh 5 lakh 8 lakh
EBIT 2.5 lakh 2.5 lakh 2.5lakh

28. • The capital Structure of Tom Gilbert Ltd consists of the following securities
45,000 10% preference shares of 100 each – 45,00,000
5,00,000 equity shares of 10 each ---------------50,00,000
The companys operating profit is Rs 12,00,000 .
Find financial leverage
What will be the new financial leverage if the operating profit increases to 18,00,000 and
interpret
• Martin Ltd has the following capital structure:
25,000 Equity shares of Rs 10 each – 2,50,000
2000 9% Pref shares of 100 each –2,00,000
3000 10% Debentures of 100 each- 3,00,000
The company’s EBIT is Rs 1,25,000. Calculate the financial leverage assuming that the
company tax bracket is 40%

29. • The capital Structure of Tom Gilbert Ltd consists of the following securities
45,000 10% preference shares of 100 each – 45,00,000
5,00,000 equity shares of 10 each ---------------50,00,000
The companys operating profit is Rs 12,00,000 . Tax bracket 40%
Find financial leverage

30. • Ascertain Financial Leverage
Net worth: 20,00,000
Debt/Equity ratio – 3:1
Interest rate 10%
Operating Profit -18,00,000
• Calculate financial leverage
Profit before depreciation, interest and tax – 80,00,000
Depreciation –12,50,000
Tax rate- 40%
EPS- 4
No of equity shares -3,15,000

31. • Find financial leverage:
Net worth – 25,00,000
Debt/Equity -3:1
Interest rate -12%
Operating Profit- 20,00,000

32. • Degree of Financial Leverage :
% change in taxable profit as a result of % change in operating profit
% change in EPS/ % change in EBIT
X Ltd Y Ltd
Equity share capital of Rs 10 each 8,00,000 3,00,000
12% debentures 50,000 5,50,000
Capital Employed 8,50,000 8,50,000
EBIT 2,55,000 2,55,000
- Interest on debentures 6000 66000
EBT 2,49,000 1,89,000
- Tax @ 35% 87,150 66,150
EAT 1,61,850 1,22,850
EPS= EAT/No of equity shares
1,61,850/80,000
2.02
1,22,850
/30,000
4.095

33. COMBINED LEVERAGE
Combined leverage = financial leverage * operating leverage
Contribution/EBIT * EBIT/EBT
= Contribution/EBT
Z ltd has a sales of 4,00,000 . The variable cost is 60% of the sale and fixed cost is Rs
8,00,000. the interest on debentures is Rs 40,000
Compute combined leverage and show the impact of taxable income when sales
increases by 5%

34. QUESTION???
• The following figures relate to two companies. Calculate all three leverages of the two
companies
X ltd Y ltd
Sales 4,00,000 8,00,000
- Variable cost
Contribution
- Fixed cost
Operating Profit (EBIT)
- Interest
Profit before tax
1,60,000
2,40,000
1,28,000
1,12,000
48,000
64,000
2,40,000
5,60,000
2,80,000
2,80,000
1,20,000
1,60,000

35. • The following projections have been given in respect of Bright co
Calculate all three leverages
Output 3,00,000 units
Fixed cost 3,50,000
Variable cost/unit 1
Interest expenses 25,000
Unit selling Price 3

36. • A firm has sales of 15,00,000 , variable cost of 9,00,000 .Fixed cost of 3,00,000 and debt
of 8,00,000 at 8%
Calculate all leverages
• The capital structure of Madan Ltd Consists of equity share capital of 8,00,000 (shares
of 100 each) and 8,00,000 of 12% debentures. Sales have increased from 80,000 units
to 1,00,000 units . The selling price is Rs 15 per unit , variable cost amounts to 9 per
unit and fixed cost amounts to 1,60,000. Tax at 50%
Calculate financial and operating leverages at both levels
Calculate percentage increase in EPS

37. • Calculate leverages under situations A, B, C from the following particulars
Installed Capacity -1200 units
Actual production and sales – 800 units
Selling price per unit – Rs 15
Variable cost per unit – Rs 10
Fixed Cost:
A -1000
B -2000
C-3000
Capital structure Plan 1 Plan 2 Plan 3
Equity 5000 7500 2500
Debt (12% 5000 2500 7500

38. • Calculate operating and financial leverage
Unit sold 5000
Variable cost per unit Rs 20
10% public debt 1,00,000
EBIT Rs 30,000
Selling price per unit Rs 30
• A firm has a sales of Rs. 20,00,000. Variable cost is Rs. 14,00,000 and fixed cost Rs. 4,00,000
and the debt is Rs. 10,00,000 at 10% rate of interest. Find out the leverages.
• Calculate leverages from the following :
Production (units) 75,000
Fixed expenses 7,00,000
Variable cost (1 unit) 7.50
Interest expenses 40,000
Selling price (1 unit) 25.00

39. • The company’s current balance sheet is as follows :
The company's total assets turnover ratio is 3.0. its fixed operating costs are Rs. 10,00,000
and variable operating cost 40%. The income tax rate is 50%.
Compute for the company all the three types of leverages
Liabilities Assets
Equity capital 6,00,000 (Rs. 10 per
share)
Net fixed assets 15,00,000
10% long term loan 8,00,000 Current assets 5,00,000
Profit and loss a/c 2,00,000
Current liabilities 4,00,000

40. • The company had the following balance sheet as on 31-03-2006
Additionally,
Fixed cost per annum (excluding interest) – 8 cr
Variable operating cost ratio :65%
Total Asset turnover ratio – 2.5
Income tax rate – 40%
Find EPS and leverages
Liabilities Amount in Cr Assets Amount in Cr
Equity share
capital
(one crore shares
of 10 each)
10 Fixed 25
Reserves and
surplus
2 Current 15
15% debentures 20
Current liabilities 8
40 40

41. • Calculate operating leverage,financial leverage for the following firms and interpret
the results.
Particulars P Q R
Output (Units) 3,00,000 75,000 5,00,000
Fixed cost (Rs.) 3,50,000 7,00,000 75000
Unit variable cost
(Rs.)
1.00 7.50 0.10
Interest expenses
(Rs.)
25,000 40,000 nil
Unit selling price 3.00 25.00 0.50

42. • Calculate the degree of financial leverage for ‘J’ Ltd. Selling price is Rs. 150. Variable
cost is Rs. 100. Fixed cost Rs. 1,20,000.Interest on debt Rs. 20,000. Tax 50%. Preference
dividend Rs. 10,000, Output 10,000 units.

43. EBIT- EPS analysis
• Sind Ltd a widely held company is considering a major expansion of the production
facilities and the following financing alternatives are available
Expected rate of return is 20%. The rate of dividend is not less than 18%. The company at
present has low debt. Corporate taxation at 35%
In lakhs X (Alt 1) Y (Alt 2) Z (Alt 3)
Equity share
capital (Rs 10
each)
60 30 10
12% Debentures - 20 25
15% loan from
financial
institution
- 10 25

44. • Dubin Ltd has equity share capital of 12,00,000 divided into shares of 100 each. It
wishes to raise further 6,00,000 for expansion cum modernisation scheme. The
company plans the following financial alternatives
A) Plan A –By issuing equity shares only
B) Plan B -2,00,000 by equity shares and 4,00,000 through debentures at 10%
C) Plan C- 2,00,000 by equity shares and 4,00,000 by issuing preference shares at 9%
D) Plan D- By raising term loan only at 10% p.a
Suggest the best alternative giving your comment assuming that the estimated EBIT after
expansion is 2,25,000 and corporate rate of tax is 40%

45. • Anderson Ltd is considering two plans to finance a project costing 50 lakh. The details
are
Sales for the first three years of operation are projected as 120,150,180 lakhs
respectively. EBIT is expected to be 15% of sales. Tax at 35%. Calculate EPS of Each plan
for three years
Plan 1 Plan 2
Equity share capital (100
per share)
20,00,000 25,00,000
12% debentures 30,00,000 25,00,000
50,00,000 50,00,000

46. CAPITAL STRUCTURE THEORIES
• Net income approach
• Net operating income approach
• Traditional approach
• Modigliani and Miller approach

47. ASSUMPTIONS FOR ALL APPROACHES
• There are to sources of funds – Equity and debt
• The total assets and capital employed is constant
• All residual earning distributed to equity shareholders
• No loss is expected to incur
• The business risk is constant not affected by change on fixed cost/operating risk
• No taxation
• No difference in investor expectations
• Cost of debt < Cost of equity

48. NET INCOME APPROACH
• Suggested by Durand
• A firm can increase its value or lower the cost of capital by increasing the proportion of
debt in capital structure (value of firm can be increased by increasing financial
leverage)
• Assumptions
a)No corporate tax
b)Cost of debt < cost of equity
c)Use of debt do not change the risk perception of investor
d) Cost of debt and cost of equity are constant

49. • Value of the firm = Market value of equity shares + market value of debt
Market value of equity shares(S) = Net income/Equity capitalisation rate
OR
Earnings available to shareholders(EAT)/ Cost of equity
i.e. V= S + D
Overall cost of capital/Weighted average cost of capital (Ko) = EBIT/value of firm

50. • Jennifer ltd is expecting an annual EBIT of 2,00,000. The company has 2,00,000 in 10%
debentures. The equity capitalisation rate (K e ) is 12%. You are required to ascertain
the total value of the firm and overall cost of capital. What happens if the company
borrows 2,00,000 at 10% to repay equity capital
• Krishna Ltd is expecting an annual EBIT of 2,00,000. The company has 7,00,000 in 10%
debentures. The cost of equity capital is 12.5%. You are required to calculate the total
value of the firm and overall cost of capital
• Bharati ltd expects an annual EBIT of Rs 1,00,000. The company has Rs 4,00,000 in 10%
debentures. The equity capitalisation rate is 12.5% .The company proposes to issue
additional equity shares of Rs. 1,00,000 and use the proceeds for redemption of
debentures of Rs 1,00,000. Calculate value of firm and overall cost of capital

51. NET OPERATING INCOME
• Suggested by Durand
• The capital structure cannot impact the value of the firm
• Value of firm is constant irrespective of financial leverage
• Market value of the firm = EBIT (net operating income) /Overall cost of capital
S= V-D
• Value of Equity (S) = Market value of firm (V) – Market value of debt (D)
• Cost of Equity =EBT(earnings after interest before tax) /Value of equity (S)

52. ASSUMPTIONS
• Ko is constant
• Split between equity and debt not important
• The use of debt increases the risk of shareholders
• No corporate tax
• Kd is constant

53. • Dewey ltdhas an EBIT of 4,50,000. The cost of debt is 10% and the outstanding debt is
12,00,000. The overall capitalisation rate (Ko) is 15% . Calculate total value of firm and
equity capitalisation rate under NOI approach
• Sun ltd expects a net operating income of 2,40,000. It has 12,00,000 10% debentures.
The overall capitalisation rate is 15%. Calculate the value of the firm and cost of equity
under NOI approach

54. NI/NOI APPROACH
• Company A and B are in the same risk class and identical. In all respects except the
company A uses debt while company B does not. Levered company has Rs 20 lakh
debentures. Carrying 12% rate of interest. Both companies earn 20% before interest
and taxes on their total assets of Rs 50 lakh.Tax rate of 50% and capitalisation rate of
10% for equity company. Compute value of both companies under a)Net income and
• Companies M and N are identical in every aspect except that the former does not use
debt in its capital structure, while the latter employs Rs 12,00,000 of 15% debt.
Assuming that a)corporate tax is 35% b)EBIT is 4,00,000 and c)equity capitalisation of
the unlevered company is 20% .What will be the value of both companies under NI.

55. TRADITIONAL APPROACH
• According to this debt can be used up to a particular level only that is advantageous
This will reduce cost of capital and increase value of firm
Beyond that particular level , using debt increases the financial risk of shareholders
Therefore cost of equity increases
• Also called Weighted average cost of capital

56. • Kincaid Ltd. has a EBIT of Rs. 6,00,000. Presently the company is entirely
financed by equity capital of Rs. 40,00,000 with equity capitalisation rate of 16%
It is contemplating to redeem a part of its capital by introducing debt financing.
It has two options a)to raise debt to the tune of 30% or b)50% of the total funds.
It is expected that for debt financing upto 30% will cost 10 % and equity
capitalization rate will rise to 17%. However, if the firm opts for 50% debt, it will
cost 12% and equity capitalization rate will be 20%.
Compute the market value of the firm, market value of equity and the overall
cost of capital.

57. • From the following data relating to Vasanth Ltd, Calculate the market value of the
company and overall cost of capital:
Net operating Income – 1,20,000/-
Total Investment – 6,00,000/-
Equity capitalisation rate:
If no debt=10%
If Debt of 2,40,000 =11%
If Debt of 3,60,000=12%
The debt of 2,40,000 can be raised at 5% rate of interest , while the debt of 3,60,000 can
be raised at 7%

58. MODIGLIANI AND MILLER APPROACH
Capital structure and cost of capital is not relevant in determining the value of the firm’
FL has no role in determine the overall cost of capital
EBIT determines the value of the firm
Propositions :
a)Market value and cost of capital are independent of the capital structure
b)Cost of equity is equal to capitalisation rate plus premium for financial risk (debt
increases more financial risk

59. • Assumptions:
The capital market is perfect free to buy and sell securities and well informed about the
risk
No tax
No transaction cost
All firms have same degree of business risk
All investor have same expectations regarding EBIT
100% payout ratio i.e. all earnings are distributed to shareholders

60. MM Approach
Buying at market with
low price and selling at a
market with high price
Arbitraging Substitution
Substituting corporate
leverage with personal
leverage

61. ARBITRAGE PROCESS/SUBSTITUTION
PROCESS
• Total value of the firm is determined by EBIT
• If two firms are identical in all aspects except their capital structure , then market value
will differ so in order to equal it we have to use arbitrage process

62. WHEN THERE ARE CORPORATE TAX
• Only when tax is applicable capital structure will have an impact on the value of the
firm and cost of capital
• How?
If firm uses debt then cost of capital is less, market value increases
Interest is deductible expense for tax purpose
A firm which uses debt(levered firm) can have more earning to equity shareholders than
a unlevered firm

63. • Value of Unlevered firm = EBIT/Ke *(1- t)
• Value of unlevered firm= EAT/Ke
• Value of levered firm = Value of unlevered firm + (Tax rate* Debt)
Two firm R and S are identical except in the method of financing. Firm R has no debt
while S has Rs 3,00,000 8% debentures in financing . Both firm have EBIT pf 1,20,000 and
equity capitalisation rate of 12%. Corporate tax at 35%. Calculate the value of the firm
using MM approach.
Merry ltd has EBIT of 30,00,000 and a 40% tax rate. Required rate on equity in the
absence of borrowing is 18%. In the absence of tax, Find the value of company
a)No leverage
b)40,00,000 lakh debt
c)70,00,000 lakh debt

64. • The value of firm K and L and equity capitalisation rate as per traditional approach is
given
Assume that a)Corporate income tax does not exist
b)Ko is 12.5%
Find value of firm as per MM approach K L
EBIT 3,00,000 3,00,000
- Interest 40,000 -
EAT 2,60,000 3,00,000
Equity Capitalization rate (Ke) 13% 12%
Market Value of equity 20,00,000 25,00,000
Market Value of Debt 8,00,000 -
Total Value of firm 28,00,000 25,00,000
WACC (Ko) 10.71% 12%

65. • The value of two firms X and Y in accordance with traditional theory are given below:
Compute the value of firm X and Y as per MM approach. Assume no tax and Ko is 12.5%
X Y
Expected operating
income
50,000 50,000
Total Cost of Debt 0 10,000
Net income 50,000 40,000
Cost of equity 0.10 0.11
Market value of shares
(S)
5,00,000 3,60,000
Market Value of debt (D) 0 2,00,000
Total Value of Firm 5,00,000 5,60,000
Ko 0.10 0.09
Debt Equity ratio 0 0.556