Q3. Two companies are identical in all respects except in the debt equity profile. Company X has 14% debentures worth Rs. 25,00,000 whereas company Y does not have any debt. Both companies earn 20% before interest and taxes on their total assets of Rs. 50,00,000. Assuming a tax rate of 40%, and cost of equity capital to be 22%, find out the value of the companies X and Y using NOI approach? Hint: use the formula K0 = [B/(B+S)]Kd + [S/(B+S)]Ke
Solution
S= 1000,000/.22 =4545454.5
B=25,00,000
=K0=[25,00,000/[2500000+4545454.5)].14+[4545454.5/2500000+4545454.5)].22
0.0496+.142 =.1915 or 19.15%
V = 5000000/0.1915 = 26,109,660.57
- Critical assumption is ko remains constant.
- An increase in cheaper debt funds is exactly offset by an increase in the required rate of return on equity.
- As long as ki is constant, ke is a linear function of the debt-to-equity ratio.
Thus, there is no one optimal capital structure.
