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FOR EXAMPLE
A companys expected annual EBIT is Rs. 50000. The company has Rs 2,00,000, 10% debenture. The cost of equity of the company is 12.5%.
SOLUTION
Net Operating Income (EBIT) Less: Interest on debentures (I) Rs 50,000 20,000 -------------------------30,000 0.125 --------------------------2,40,000 2,00,000
Earnings available to equity holders (NI) Equity Capitalization Rate (ke) Market Value of Equity (S) = NI/Ke
----------------------------4,40,000 11.36
EXAMPLE
A companys expected annual EBIT is Rs. 50000. The company has Rs 2,00,000, 10% debenture. The cost of equity of the company is 12.5%.
Ke
= (EBIT I)/(V B) = Earning available to equity holders/Total market value of equity shares
SOLUTION
Net Operating Income (EBIT)
Overall capitalisation rate (Ko)
Rs. 50,000
0.125 ---------------------------Rs 4,00,000 Rs 2,00,000 Rs 2,00,000
Total market value of the firm (V) = EBIT/Ko Total Value of Debt Total Market Value of Debt (S) = (V B)
MM APPROACH
MM approach support the NOI approach, it means capital structure and cost of capital is irrelevant to value of the firm. Basic Propositions of the MM approach -- The overall cost of capital (ko) and the value of the firm (V) are independent of its capital structure. The total value is given by capitalizing the expected stream of operating earnings at a discount rate appropriate for its risk class. -Ke increases in a manner to offset exactly the use of a less expensive source of funds represented by debt.
ARBITRAGE PROCESS
The MM approach illustrates the arbitrage process with reference to valuation in terms of two firms which are exactly similar in all respects except leverage so that one of them has debt in its capital structure while the other does not.
To understand the process let us have an example
EXAMPLE
Assume there are two firms, L and U, which are identical in all respects except the firm L has 10% Rs 5,00,000 debentures. The EBIT of both the firms are equal, that is, Rs 1,00,000. The equity capitalization rate (Ke) of firm L is higher (16%) then that of firm U (12.5%).
Solution:
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