Company finances its assets by capital structure. It can finance its assets by either only equity or combination of debt and equity.Modigliani and miller proposed a theory in 1950s, which says, valuation of a company is irrelevant to its capital structure. It is also irrelevant, to whether company is highly ... Read More

Return on investment Operating leverage Financial leverage Combined leverageRs.Sales (S)1000000Variable cost (VC)375000Fixed cost (FC)95000Debt425000Interest on debt10%Equity capital590000SolutionThe solution is given below −return on investment = EBIT/ (D + E) return on investment = (S – VC – FC)/ (D + E) return on investment = (1000000 – 375000 – 95000)/ (425000 + 590000) ... Read More

SolutionThe solution is given below −Interest cost = 12% (250000) = 30000/- Earnings = EBIT – Interest cost = 50000 – 30000 = 20000/- (no tax rate) Shareholders earnings = earnings Shareholders earnings = 20000/- Market value (equity) E = shareholder’s earnings/ cost of equity Market value ... Read More

Capital structure plays an important role in value of a company. Different companies have different capital structures like some have capital based on debt, some have based on equity and some have a mixed or combination of both in their financial mix.Durand proposed net income approach and he states that ... Read More

The major differences between net operating income and net income are as follows −Net operating incomeNo relevance in capital structure.Degree of leverage is irrelevant to cost of capital (assumes).It has constant cost of capital.Equity value is residual.Changes perception of investor with increase in debt.Net incomeRelevance in capital structure.Change in degree ... Read More

SolutionThe solution is as follows −Debt ratioEquityDebtCost of debtWACCInterest Expenses (I)Market value of a company (V)Market value of Equity (E)Net operating income (EBIT – I)Cost of equity (Ke)0.003500000010%11.5%03625000362500362500010%0.20280000070000010%11.5%70000362500029250035550008.07%0.451925000157500010%11.5%157500362500020500034675005.65%0.702450000245000010%11.5%245000362500011750033800003.24%1.000350000010%11.5%35000036250001250032750000.35%Equity = book value * (1-debt ratio)Debt = book value * debt ratioInterest (I) = debt * cost of borrowedMarket value of a ... Read More

SolutionThe solution is given below −Value of firm and cost of equity can be calculated by following procedure −Market value of a firm (V) is ratio of earnings before income taxes (EBIT) and weighted average cost of capital (WACC).V = EBIT/WACC V = 95000/12.5% V = 760000Total Equity (E) is ... Read More

Capital structure of a company depends on mix or ratio of debt and equity in their mode of their financing. Depending on what company prefer, some may have more debt or more equity in financing their asset, but final goal is to maximize their market value and their profits.Net operating ... Read More

Company XCompany YRsRsNet operating income2000020000Cost of debt02500Net income2000017500Cost of equity0.080.10Market value of shares250000175000Market value of debt050000Total value of firm250000225000Cost of capital (Avg)0.950.08Debt equity ratio00.8Assumptions: 1) no corporate tax 2) equilibrium value is 12%.SolutionThe solution is explained below −Company XCompany YRsRsNet operating income2000020000(-)Cost of debt02500Net income2000017500Equilibrium cost of equity (12.5%)0.1250.125Value of ... Read More

SolutionThe solution is given below −Company X is unlevered, which means, interest on debt is 0.Company y is levered, which means, interest on debt is 7000 (175000*4%)Market valueCompany XCompany YRsRsNet operating income4500045000Interest on debt070004500038000Profit before taxes4500038000Taxes (40%)18000152002700022800Capitalization rate (12%)0.120.12Market value equity225000190000Market value of debt0175000Total value225000365000