Capital Structure Theories^265Let us repeat the example we discussed earlier in net income approach. Let us take a
company that has an investment of Rs 1,00,000 and an net operating income of Rs
10,000. It is considering two scenarios: 1) no debt and 2) equal levels of debt and equity
of Rs 50,000 each. Let us say that the company finds out that the overall cost of capital
is 8% and the cost of debt is 6%.
Calculations show that equity earnings would be Rs 10,000 and Rs 7,000 respectively in
the two scenarios as shown below. As the return expected on total capital is 8 per cent,
therefore the market value of total capital would be such that this return becomes 8 per
cent on the same. This means that the market value of capital would be Rs 1,25,000 in
both the scenarios as our assumption in this case is that the total market value remains
constant. Also the value of debt would also remain constant as the cost of debt remains
constant. This means that the equity capitalisation can be calculated by subtracting the
market value of debt from the total market value of the firm. Then the return on equity
divided by the market capitalisation of equity would give us the cost of equity.The equity capitalisation rates of scenario A and B are as follows :
Scenario A Equity earnings = 10,000 = 0.08 = 8 %
Market value of equity 1,25,000
Scenario B : Equity earnings = 7,000 = 0.0933 = 9.33%
Market value of equity 75,000Scenario A Scenario BEquity 1,00,000 50,000
Debt 0 50,000
Cost of debt 6% 6%
Net Operating income 10,000 10,000
Overall capitalisation rate 8 % 8 %
Total market value 1,25,000 1,25,000
Interest on debt 0 3000
Debt capitalisation rate 0.06 0.06
Market value of debt 0 50,000
Market value of equity 1,25,000 75,000
Degree of leverage 0.0