Computation of overall cost of capital, Financial Management

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Q. Computation of overall Cost of Capital?

Computation of Value of the Firm (V) & Overall Cost of Capital when debt is lowered to Rs, 1, 00,000

When the debt is lowered to Rs. 1, 00,000 then Value of Firm:

NI = EBIT - Interest                          = 50,000 - 10,000 = 40,000

Interest = 1, 00,000 x 10/100--- = 10,000

Value of Equity (S) =   40,000 / 12.5 % =   40,000 / 12.5 X 100 = 3, 20,000

Value of Equity (S) = 3, 20,000 Value of Debt = 1, 00,000

Value of the Firm = S + B = 3, 20,000 + 1, 00,000 = 4, 20,000

Computation of Overall Cost of Capital:

Ko = EBIT / V X 100 = 50,000/4, 20,000 X 100 = 11.90%

Value of the Firm = 4, 2,000 Overall Cost of Capital = 11.90% therefore we find that the decrease in leverage has increase the overall cost of capital and has decreased the value of the firm.

Censure of Net Income Approach:

(i) Incorrect assumption of no corporate taxes.

(ii) Incorrect assumption of constant equity capitalization rate.

(iii) incorrect assumption of constant debt capitalization rate.

(iv) Incorrect assumption of constant risk perception.


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