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372 Corporate Finance BRILLIANT’S

Add: Value of Debts (B) 5,00,000 Nil
V = (S + B) 8,75,000 5,62,500

 B   S 
K = K    K e  

o d V   V 
Where, K = K (1 – t) = 15 (1 – 0.5) = 7.5%
d i

 5,00,000   3,75,000 
Firm P : = 7.5    20   = 7.5 × 0.571 + 20 × 0.429
 8,75,000   8,75,000 
= 12.86%
(b) NOI Approach : The NOI approach is based on the assumption that there is no tax.
However, in the present case, both the firms have tax liability @ 50%. So, their valuation may be
found by applying the MM model (with taxes) which is an extension of NOI approach. Under the
NOI approach, the value of levered firm is taken as equal to the value of unlevered firm plus the
premium for interest tax shield on debt financing.
Thus, V = V + Debt (t)
L u
Where, V refers to the value of levered firm, V refers to value of unlevered firm and ‘t’ refers
L u
to the tax rate applicable to the levered firm.
Valuation of Firm Q (Unlevered Firm):
V = EBIT (1–t)/K = 2,25,000(0.5)/0.20 = ` 5,62,500
Q e
Now, the valuation of Firm P (Levered firm) is:
V = V + Debt(t) = 5,62,500 + 5,00,000 (0.50) = ` 8,12,500
P Q
Now, the value of Equity is 8,12,500 – 5,00,000 = 3,12,500, and the equity capitalization rate K
e
= 75,000/3,12,500 = 24%. The overall capitalization rate, K , may be found as follows:
o
5,00,000 3,12,500
= 7.5%  24% = 4.62% + 9.23% = 13.85%
8,12,500 8,12,500
So, the WACC of firm P is 13.85%. Under both the NI approach and NOI approach, the Firm
P seems to have the optimal Capital structure as it is having higher total value than the value of
the firm Q. 

REVIEW QUESTIONS
Q.1. Write a short note on: Different Capital Structure Theories.
{d{^ÝZ H¡${nQ>b ñQ´>³Ma ϶moarO na g§{jßV {Q>ßnUr {b{IE& [See Q.33]
Q.2. Explain the assumptions and implications of Net Income approach.
ZoQ> B§H$‘ EàmoM H$s EOåneÝg VWm BpåßbHo$eÝg H$m dU©Z H$s{OE& [See Q.34]