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BRILLIANT’S Capital Structure Theories 349

Illustration 4.2.8
(a) A company expects a net operating income of ` 1,00,000. It has ` 5,00,000 (6%) Debentures.
The overall capitalization rate is 10%. Calculate the value of the firm and the equity
capitalization rate (cost of equity) according to the Net Operating Income Approach.
EH$ H§$nZr ZoQ> Am°naoqQ>J B§H$‘ < 1,00,000 H$s Anojm H$aVr h¡& BgHo$ nmg < 5,00,000> (6%)
{S>~|Mg© h¢& g§nyU© H¡${nQ>bmBOoeZ aoQ> 10% h¡& ZoQ> Am°naoqQ>J B§H$‘ En«moM Ho$ AZwgma g§ñWm H$m ‘yë¶ VWm
B{³dQ>r H¡${nQ>bmBOoeZ (B{³dQ>r H$s H$m°ñQ>) H$s JUZm H$s{OE&

(b) If the debenture is increased to ` 7,50,000. What will be the effect on the value of the firm
and the equity capitalization rate?
¶{X {S>~|Ma < 7,50,000 ~‹T> OmVm h¡& g§ñWm Ho$ ‘yë¶ VWm B{³dQ>r H¡${nQ>bmBOoeZ aoQ> na ³¶m n«^md hmoJm?

Solution:
(a) Net Operating Income = ` 1,00,000
Overall Cost of Capital = 10%
Net Operating Income  EBIT 100
Market Value of the Firm (V) =   = 1,00,000  = ` 10,00,000
Overall Cost of Capital  K o  10
Market Value of Firm ` 10,00,000
Less: Market Value of Debentures ` 5,00,000
Total Market Value of Equity ` 5,00,000
Equity Capitalization Rate or Cost of equity (K )
e
Earnings Available to Equity Shareholders  EBIT-I 
or  
Total Market Value of Equity Shares  V-B 
where, EBIT is Earnings Before Interest and Tax
V is the Value of firm
B is Value of debt capital
I is the interest on debt
1,00,000 30,000 70,000
=  100 =  100 14%
10,00,000 5,00,000 5,00,000

(b) If the debenture is increased to ` 7,50,000, the value of the firm shall remain unchanged
at ` 10,00,000. The equity capitalization rate will increase as follows:
Equity Capitalization Rate (K )
e
EBIT I 1,00,000 45,000
= =  100

V B 10,00,000 7,50,000
55,000
=  100 = 22% 
2,50,000