Question 3 OR (c)
Net income approach: value and overall cost of capital
9 marks
- Time to write
- About 18 minutes
Question
Question 3 OR (c) · 9 marksThe following information is provided by Pluto Ltd & Comet Ltd.
• Pluto Ltd:
o EBIT: Rs. 2,70,000
o 15% Debt: Rs. 6,00,000
o Ke (cost of equity) 20%
• Comet Ltd:
o EBIT: Rs. 2,70,000
o Ke (cost of equity) 20%
Using the Net Income Approach (NI), calculate Ko (overall cost of capital) & the value of the firm for Pluto Ltd. & Comet Ltd.
If the Pluto Ltd. increase total Debentures from Rs. 6,00,000 to Rs. 8,40,000, how will the value of the firm and ko (overall cost of capital) be affected?
Comet Ltd raise the extra funds 15% Debentures of Rs. 3,60,000. How will this affect the firm's value and ko (overall cost of capital)?
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
- How…?Two asks in one question: answer both.
- calculateFormula first, then the working, then the answer with its unit (₹, %, units).
What the paper leaves open
Part (iii) is read as: the second company raises additional funds of the stated amount through 15% debentures, with its EBIT unchanged. The grammar of part (ii) ("If the... Ltd. increase") is printed so and kept.
Write it in this order
- Read the data; note exactly what is asked 1 min
- 1 (i) Values and ko of both firms 3 marks 5 min
- 2 (ii) Effect of more debt on Pluto 3 marks 5 min
- 3 (iii) Effect of debentures on Comet 3 marks 5 min
- Check: arithmetic, units (₹, %), final answer underlined 2 min
Try it first. About 18 minutes for 9 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.
Under the net income approach, kd (15%) and ke (20%) stay constant whatever the debt, so using more of the cheaper debt raises the value of the firm and lowers ko. Value of equity = earnings for equity (EBIT − interest) ÷ ke; value of firm = equity + debt; ko = EBIT ÷ value of the firm. No taxes are given.
| ₹ | (i) Pluto Ltd. | (i) Comet Ltd. | (ii) Pluto, debt ₹8,40,000 | (iii) Comet, with ₹3,60,000 debentures |
|---|---|---|---|---|
| EBIT | 2,70,000 | 2,70,000 | 2,70,000 | 2,70,000 |
| Less: interest @ 15% | 90,000 | — | 1,26,000 | 54,000 |
| Net income for equity | 1,80,000 | 2,70,000 | 1,44,000 | 2,16,000 |
| Value of equity (÷ 20%) | 9,00,000 | 13,50,000 | 7,20,000 | 10,80,000 |
| Value of debt | 6,00,000 | — | 8,40,000 | 3,60,000 |
| Value of the firm | 15,00,000 | 13,50,000 | 15,60,000 | 14,40,000 |
| Overall cost of capital (EBIT ÷ V) | 18.00% | 20.00% | 17.31% | 18.75% |
(ii) Raising Pluto's debentures from ₹6,00,000 to ₹8,40,000 raises the value of the firm by ₹60,000 (to ₹15,60,000) and lowers ko from 18% to 17.31%.
(iii) With ₹3,60,000 of 15% debentures (EBIT unchanged, paper note), Comet's value rises by ₹90,000 (to ₹14,40,000) and its ko falls from 20% to 18.75%.
Both results follow the net income approach: replacing equity at 20% with debt at 15% lowers the overall cost of capital and increases the value of the firm.
Where the 9 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | (i) Values and ko of both firms | 3 |
| 2 | (ii) Effect of more debt on Pluto | 3 |
| 3 | (iii) Effect of debentures on Comet | 3 |
| Total | 9 |
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