Question 3 (a)
Value of two firms under the net income approach
9 marks
- Time to write
- About 18 minutes
Question
Question 3 (a) · 9 marksNova. Ltd. and Maple Bakery. Ltd. belong to the same risk class and are identical in every respect except that company Nova uses debt while company Maple Bakery does not. The levered firm has ₹13,20,000 debentures carrying interest at a 10% rate. Both firms earn a 20% operating profit on their total assets of ₹24 lakhs. Both companies have the same capitalisation rate of 15% on all equity shares. Compute the value of Nova Ltd. and Maple Bakery Ltd. using the Net Income approach.
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
- ComputeFormula first, then the working, then the answer with its unit (₹, %, units).
What the paper leaves open
Both company names are printed with a stray full stop before "Ltd."; the reworded names keep it.
Write it in this order
- Read the data; note exactly what is asked 1 min
- 1 EBIT and net income for equity 2 marks 4 min
- 2 Value of equity and of each firm 5 marks 9 min
- 3 Overall cost of capital and comment 2 marks 3 min
- Check: arithmetic, units (₹, %), final answer underlined 1 min
Short on time? Step 2 carries 5 of the 9 marks: guard its minutes.
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, the costs of debt and of equity stay constant whatever the leverage, so using more of the cheaper debt lowers the overall cost of capital and raises the value of the firm. The value of equity is the net income for equity capitalised at ke, and the value of the firm is equity plus debt.
Operating profit (EBIT) of each firm = 20% × ₹24,00,000 = ₹4,80,000. No taxes are given.
| ₹ | Nova Ltd. (levered) | Maple Bakery Ltd. (unlevered) |
|---|---|---|
| EBIT | 4,80,000 | 4,80,000 |
| Less: interest (10% × 13,20,000) | 1,32,000 | — |
| Net income for equity | 3,48,000 | 4,80,000 |
| Equity capitalisation rate (ke) | 15% | 15% |
| Value of equity (NI ÷ ke) | 23,20,000 | 32,00,000 |
| Value of debt | 13,20,000 | — |
| Value of the firm | 36,40,000 | 32,00,000 |
| Overall cost of capital (EBIT ÷ value) | 13.19% | 15.00% |
Comment. Nova Ltd., which uses debt, is worth ₹4,40,000 more and has a lower overall cost of capital, as the net income approach predicts: replacing equity at 15% with debt at 10% lowers ko. (Under the net operating income view the two would be worth the same.)
Where the 9 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | EBIT and net income for equity | 2 |
| 2 | Value of equity and of each firm | 5 |
| 3 | Overall cost of capital and comment | 2 |
| Total | 9 |
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