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342 Corporate Finance BRILLIANT’S

Equity Capitalization Rate = 10%

100
Market Value of Equity = 64, 000  (`) = 6,40,000
10
Market Value of Debentures (`) = 2,00,000
Value of the Firm (`) = 8,40,000
Calculation of Overall Capitalization Rate
Earnings  EBIT  80,000
Overall Cost of Capital (K ) = OR   =  100 = 9.52%
0 Value of thefirm  V  8,40,000
(b) Calculation of value of the firm if debenture is increased to ` 3,00,000. (`)
Net Income 80,000
Less: Interest on 8% Debentures of ` 3,00,000 24,000
Earning available to equity shareholders 56,000
Equity Capitalization Rate = 10% (`)
100
Market Value of Equity = 56,000  = 5,60,000
10
Market Value of Debentures = 3,00,000
Value of the Firm = 8,60,000

80,000
Overall Capitalization Rate =  100 = 9.30% .
8,60,000
Thus, it is evident that with the increase in debt financing, the value of the firm has increased
and the overall cost of capital has decreased.
Illustration 4.2.3
A company has earnings of ` 1,00,000. The capital structure of the company contains debt
as well as equity in which debt is ` 4,00,000 borrowed at the rate of 10%. Presently the cost of
equity capital of the company is 12.50%. Find out the total value of the company and the overall
cost of capital using Net Income approach. If debt is increased or reduced by ` 1,00,000 what
will be the effect on value of the company and on overall cost of Capital as per Net Income
Approach.
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