Question 3 OR (b)
Net Income and Net Operating Income approaches, with tax
11 marks
- Time to write
- About 22 minutes
From an older CBCS paper
Question
Question 3 OR (b) · 11 marksTwo firms, A Ltd. and B Ltd., belong to a homogeneous risk class, except in terms of capital structure. From the information below, determine their value under (i) the Net Income approach and (ii) the Net Operating Income approach:
| Particulars | A Ltd. | B Ltd. |
|---|---|---|
| Earnings before interest and tax (EBIT) | ₹ 2,70,000 | ₹ 2,70,000 |
| Interest (0.15) | ₹ 90,000 | — |
| Equity Capitalisation Rate | 0.20 | 0.20 |
| Rate of tax | 0.35 | 0.35 |
11
Reworded from the university paper: names and figures differ, the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.
Before you write
Read off the question and its marks
Read from the question
- determineFormula first, then the working, then the answer with its unit (₹, %, units).
What the paper leaves open
Under the Net Operating Income approach, the overall capitalisation rate is not given; the answer takes it as the all-equity firm's rate (0.20) and states this.
Write it in this order
- Read the data; note exactly what is asked 1 min
- 1 Debt and earnings for equity after tax 2 marks 4 min
- 2 NI approach: values of both firms 4 marks 8 min
- 3 NOI approach: values of both firms, equity and implied cost 4 marks 7 min
- 4 Conclusion 1 mark 1 min
- Check: arithmetic, units (₹, %), final answer underlined 1 min
Short on time? End with step 4's one-line conclusion, whatever happens: never leave the figures without it.
Try it first. About 22 minutes for 11 marks. Write it out, then open the solution.
Solution
Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.
Debt of A Ltd. = interest ÷ rate = 90,000 ÷ 0.15 = ₹6,00,000. Tax at 35%.
(i) Net Income approach. The costs of debt and equity do not change with leverage, so more debt raises the value of the firm. The earnings for equity after tax are capitalised at 0.20, and debt is added at its value.
| Particulars (₹) | A Ltd. | B Ltd. |
|---|---|---|
| EBIT | 2,70,000 | 2,70,000 |
| Less: interest | 90,000 | Nil |
| EBT | 1,80,000 | 2,70,000 |
| Less: tax @ 35% | 63,000 | 94,500 |
| Earnings for equity | 1,17,000 | 1,75,500 |
| Value of equity (÷ 0.20) | 5,85,000 | 8,77,500 |
| Value of debt (90,000 ÷ 0.15) | 6,00,000 | Nil |
| Value of the firm | 11,85,000 | 8,77,500 |
(ii) Net Operating Income approach. The market values the firm as a whole: the overall capitalisation rate stays the same whatever the debt–equity mix, so the value of the firm does not depend on its capital structure, the cheaper debt being offset by a higher cost of equity. The overall rate is taken as the all-equity firm's, 0.20 (paper note), applied to the operating income after tax, EBIT(1 − t) = ₹1,75,500, the income available to all investors.
| Particulars (₹) | A Ltd. | B Ltd. |
|---|---|---|
| Operating income after tax, EBIT(1 − t) | 1,75,500 | 1,75,500 |
| Value of the firm (÷ 0.20) | 8,77,500 | 8,77,500 |
| Less: value of debt | 6,00,000 | Nil |
| Value of equity | 2,77,500 | 8,77,500 |
| Implied cost of equity (1,17,000 ÷ 2,77,500; 1,75,500 ÷ 8,77,500) | 42.16% | 20% |
Conclusion. Under NI, A Ltd. is worth more because of its debt (₹11,85,000 against ₹8,77,500); under NOI both are worth ₹8,77,500, A's cost of equity rising to 42.16%. (If the overall rate is applied to EBIT before tax, as in the no-tax form of the NOI approach, each firm is worth 2,70,000 ÷ 0.20 = ₹13,50,000.)
Where the 11 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Debt and earnings for equity after tax | 2 |
| 2 | NI approach: values of both firms | 4 |
| 3 | NOI approach: values of both firms, equity and implied cost | 4 |
| 4 | Conclusion | 1 |
| Total | 11 |
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