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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