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Question - A company's current earnings before interest and taxes are Rs 5,00,000. The firm currently has outstanding Rs 10 lakh of debts at an average cost of 8 per cent. Its cost of equity capital is estimated to equal 12 per cent.
a. Determine the current value and overall capitalization rate of the firm using the Net Income Approach. Comment on the impact of increase in debentures on the value of the firm as per Net Income Approach.
b. The firm is considering reducing its debt by Rs 5 lakhs. The cost of debt and EBIT is expected to be unaffected. However, the firm's cost of equity capital is to be reduced to 10 per cent due to decrease in financial risk. Would you recommend the proposed action (Based on value of firm and overall cost of capital)? Show relevant calculations using Net Income Approach.
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