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340 Corporate Finance BRILLIANT’S

We can graph the relationship between the h_ crdaoO Ho$ ñVa Ho$ gmW {d{^Þ ’¡$³Q>g© (K , K,
e i
various factors (K , K, K ) with the degree of K ) Ho$ _Ü` g§~§Y H$mo J«m\$ na Xem© gH$Vo h¡Ÿ& My±{H$ `h
e i o o
leverage. Since, the assumption is that K and K AdYmaUm h¡ {H$ K Ed§ K An[adV©Zr` ah|Jo AV: crdaoO
e i
i
e
remain unchanged, we find that as the leverage ~‹T>Zo Ho$ gmW K KQ>Vm h¡ Ed§ O~ crdaoO 1 hmo OmVm h¡
increases, K decreases and approaches to cost o
o V~ S>oãQ> H$s H$m°ñQ> Ho$ ~am~a hmo OmVm h¡ (K = K)Ÿ& Bg
of debts when leverage is 1, i.e. (K = K). At this o i
o i {~ÝXw na \$_© H$s gånyU© cmJV H$_ go H$_ hmoJrŸ& Bg
point, the firm’s overall cost would be minimum.
Thus, NI approach indicates that the firm can àH$ma, NI AàmoM `h Xem©Vr h¡ {H$ \$_© 100% F$U H$mo
employ 100% debt to maximize its value. CgH$s d¡ë`y VH$ ~‹T>m gH$Vr h¡Ÿ&
y

20
K e
(%)
Ko K o
and 16
K , i K i
,
K e
10

x
0 0.5 1.0
Degree of Leverage (B/V)
Fig.: Leverage and Cost of Capital (NI Approach)

 When there is no Tax Rate / O~ H$moB© Q>¡³g aoQ> Zht h¡

Illustration 4.2.1
Assuming no taxes and given the earnings before interest and taxes (EBIT) interest (I), at 10%
and equity capitalization rate (K), below, calculate the total market value of each firm:
‘mZm {H$ H$moB© Q>¡³g Zht h¡ VWm ZrMo {X¶o J¶o 10% na A{Zª½g {~’$moa B§Q>aoñQ> E§S> Q>¡³gog (EBIT) B§Q>aoñQ> (I) VWm
B{³dQ>r H¡${nQ>bmBOoeZ aoQ> (K) go à˶oH$ g§ñWm Ho$ ~mOma ‘yë¶ H$s JUZm H$s{OE…

Firms EBIT (`) I (`) K (`)
e
X 2,00,000 20,000 12.0%
Y 3,00,000 60,000 16.0%
Z 5,00,000 2,00,000 15.0%
W 6,00,000 2,40,000 18.0%
Also determine the weighted average cost of capital for each firm.
à˶oH$ g§ñWm Ho$ {bE H¡${nQ>b H$s d¡Q>oS> EdaoO H$m°ñQ> H$m {ZYm©aU H$s{OE&