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Numericals with solutions of Net income Approach


Net income approach questions and answers: 

Questions: Find out the value of the firm with the help of given information:
Particulars
Amount
Earnings before interest and tax
3, 50, 000
Cost of equity
10%
Cost of debt
7.2%
Debenture
1,00,000
Find out the overall cost of capital with the help of net income approach. (Assume tax rate-10%)

Solution:
Particulars
Amount
Earnings before interest and tax
3, 50, 000
Less: Interest @7.2%
7, 200
Earnings before tax
3, 42, 800
Less: Tax@10%
34, 280
Net income
3, 08, 520
Cost of equity
10%
Market value of equity (S =net income/ cost of equity)
30, 85, 200
Market value of debt (B)
1, 00, 000
Value of the firm (S+B)
31, 85, 200

Questions: Find out the overall cost of capital if the equity capitalisation rate is 12%. The earnings before interest and tax are Rs. 6, 50, 000. The debenture rate 8% of Rs.3, 00, 000. The tax rate is nil.
a.       The debt amount is decreases from Rs. 3, 00,000 to Rs. 2, 50,000. Find out the value of the firm.
b.      The debt amount is increases from Rs. 3, 00,000 to Rs. 5, 50,000. Find out the value of the firm.

Solution:
Particulars
Amount
Earnings before interest and tax
6, 50, 000
Less: Interest @8%
24, 000
Earnings before tax
6, 26, 000
Less: Tax
Nil
Net income
6, 26,000
Cost of equity
12%
Market value of equity (S)
52, 16, 667
Market value of debt (B)
3, 00, 000
Value of the firm (S+B)
55, 16, 667

Working notes:
Market value of equity = net income/ cost of equity
= 6, 26, 000 / 12/100
= 6, 26, 000/ 0.12
= Rs. 52, 16, 667

Debenture amount decreases from Rs. 3, 00, 000 to 2, 50, 000
Particulars
Amount
Earnings before interest and tax
6, 50, 000
Less: Interest @8%
20, 000
Earnings before tax
6, 30, 000
Less: Tax
Nil
Net income
6, 30,000
Cost of equity
12%
Market value of equity (S) net income/ cost of equity
52, 50, 000
Market value of debt (B)
2, 50, 000
Value of the firm (S+B)
55, 00, 000

Debenture amount increases from Rs. 3, 00, 000 to Rs. 5, 50,000.

Particulars
Amount
Earnings before interest and tax
6, 50, 000
Less: Interest @8%
44, 000
Earnings before tax
6, 06, 000
Less: Tax
Nil
Net income
6, 06,000
Cost of equity
12%
Market value of equity (S) net income/ cost of equity
50, 50, 000
Market value of debt (B)
5, 50, 000
Value of the firm (S+B)
56, 00, 000

If debt amount decreases from Rs. 3, 00, 000 to Rs. 2, 50, 000 then the value of the firm decreases to Rs. 16, 000. If debt amount increases from Rs. 3, 00, 000 to Rs. 5, 50, 000 then the value of the firm increases to Rs. 1, 00, 000. So, the value of the firm increases when the debt capital is used more than the equity capital.






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