Question 3 OR (a)
NOI approach: value of the firm and the cost of equity as debt changes
8 marks
- Time to write
- About 16 minutes
From an older CBCS paper
Question
Question 3 OR (a) · 8 marksA company's EBIT is ₹ 3,60,000, and its overall cost of capital 12.5%. It has debt of ₹ 6,00,000, borrowed @ 8%. Using the NOI approach, find the company's value. Also show how change in debt by ₹ 3,60,000 have impact on the company's cost of equity. 8
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
- findFormula first, then the working, then the answer with its unit (₹, %, units).
What the paper leaves open
The change in debt is not said to be an increase or a decrease; the answer works both and states this.
Write it in this order
- Read the data; note exactly what is asked 1 min
- 1 Value of the company 2 marks 4 min
- 2 Present cost of equity 2 marks 3 min
- 3 Cost of equity after the change in debt both directions 3 marks 5 min
- 4 Comment 1 mark 2 min
- Check: arithmetic, units (₹, %), final answer underlined 1 min
Try it first. About 16 minutes for 8 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.
NOI approach. The overall cost of capital (ko) is constant, so the value of the firm is EBIT ÷ ko whatever the debt; the value of equity is the residual, and the cost of equity rises (or falls) with leverage so as to keep ko unchanged.
Value of the company = 3,60,000 ÷ 12.5% = ₹28,80,000.
The question does not say whether debt rises or falls by ₹3,60,000 (paper note), so both are shown.
| Particulars (₹) | Present | Debt raised by 3,60,000 | Debt cut by 3,60,000 |
|---|---|---|---|
| Value of the firm (V) | 28,80,000 | 28,80,000 | 28,80,000 |
| Less: debt (D) | 6,00,000 | 9,60,000 | 2,40,000 |
| Value of equity (S) | 22,80,000 | 19,20,000 | 26,40,000 |
| EBIT | 3,60,000 | 3,60,000 | 3,60,000 |
| Less: interest @ 8% | 48,000 | 76,800 | 19,200 |
| Earnings for equity | 3,12,000 | 2,83,200 | 3,40,800 |
| Cost of equity (ke = earnings ÷ S) | 13.68% | 14.75% | 12.91% |
Impact. Raising the debt raises the cost of equity from 13.68% to 14.75%; reducing it lowers ke to 12.91%. In every case ko = ke × S/V + kd × D/V = 12.5%: the benefit of cheaper debt is exactly offset by the change in ke, so the value of the firm stays ₹28,80,000.
Where the 8 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Value of the company | 2 |
| 2 | Present cost of equity | 2 |
| 3 | Cost of equity after the change in debt (both directions) | 3 |
| 4 | Comment | 1 |
| Total | 8 |
Report a problemopens an email to admin@getkunji.com with the question ID1251-Q3aORalready filled in.