Untitled-29

Capital Structure Theories^289

ke We kd Wd ke We kdWd k 0

(1) (2) (3) (4) (5) (6) (7)=(5)+(6)

0.100 1.0 - - 0.100 - 0.1000

0.105 0.9 0.040 0.1 0.095 0.0040 0.0985

0.110 0.8 0.040 0.2 0.080 0.0080 0.0960

0.116 0.7 0.045 0.3 0.082 0.0135 0.0947

0.124 0.6 0.050 0.4 0.074 0.0200 0.0944

0.135 0.5 0.055 0.5 0.065 0.0275 0.0950

0.160 0.4 0.060 0.6 0.060 0.0360 0.1000

0.200 0.3 0.080 0.7 0.060 0.0560 0.1160

The firm should employ debt of Re 4,00,000 as the weighted average cost of capital
is minimum at this level of debt.

(b) According to the M-M approach, the cost of capital is a constant, and the cost
of euqity increases linearly with debt. The equilibrium cost of capital is assumed
to be equal to pure equity capitalisation rate, which is 10 per cent in the present
problem. The equity capitalisation rate is given by the following formula:

ke = k 0 + (k 0 - kd) )*



The equity capitalisation rates will be:

Debt kd k 0 (k 0 ñ kd) Debt/Equity ke

Rs

0 - 0.10 + (0.10-0.000) 0 = 0.1000

1,00,000 0.040 0.10 + (0.10-0.040) 1,00,000/9,00,000 = 0.1067

2,00,000 0.040 0.10 + (0.10-0.040) 2,00,000/8,00,000 = 0.1150

3,00,000 0.040 0.10 + (0.10-0.045) 3,00,000/7,00,000 = 0.1236

4,00,000 0.050 0.10 + (0.10-0.050) 4,00,000/6,00,000 = 0.1333

5,00,000 0.050 0.10 + (0.10-0.055) 5,00,000/5,00,000 = 0.1450

6,00,000 0.060 0.10 + (0.10-0.060) 6,00,000/4,00,000 = 0.1600

7,00,000 0.080 0.10 + (0.10-0.080) 7,00,000/3,00,000 = 0.1467

Problem 2: The Levered Company and the Unlevered Company are indentical
in every respect except that the Levered Company has 6 per cent Rs 2,00,000
debt outstanding. As per the NI approach, the valuation of the two firms is as
follows: