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348 Corporate Finance BRILLIANT’S

Solution:
Total Value of the Firm (Net Operating Income Approach)
Net Operating Income (EBIT) ` 50,000
Overall capitalization rate (K ) 0.125
o
EBIT
Total market value of the firm (V) = 4,00,000
K
O
Less: Total value of debt (B) 2,00,000
Total market value of equity (S) = (V–B) 2,00,000
EBIT I
Equity capitalization rate, K =
e V B
Earnings available to equity holders 50,000 – 20,000
= = 0.15
Total market value of equity shares 2,00,000

 2,00,000
Alternatively, K = K + (K – K)B/S = 0.125 + (0.125 – 0.10)   = 0.15
e o o i  2,00,000 
The weighted average cost of capital to verify the validity of the NOI Approach:

 2,00,000  2,00,000
K = K(B/V) + K (S/V) = 0.10   + 0.15   = 0.125
o i e  4,00,000   4,00,000 
Thus, we find that the overall cost of capital is 12.5 percent as per the requirement of the
NOI Approach.
y

K e
25.0
(%) 20.0
,and K 0 15.0

, K i K 0
K e 10.0 K i

5.0

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