Capital Structure Theories^263
As our assumption is that the cost of debt and equity capital would not change with the
change in the level of leverage, Ko is seen to go down with the increasing proportion of
debt in the capital.
Note that we are talking about the market value of debt and the market value of equity.
Many times we confuse it with the book values of debt and equity, a measure that
always leads to problems in measuring the true costs of debt and equity.
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 cost
of equity is 10% 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 equity is 10%, we can
say that this profit is 10% and therefore the market value of equity would be such that
this return becomes 10% on the same. This means that the market value of equity
would be Rs 1,00,000 and Rs 70,000 respectively in the two scenarios. Adding the
market value of debt and the market value of equity gives us the total value of the firm
in the market.
Average cost of capital:
Scenario A: 6% (0 / 100000) + 10% (100000 / 100000) = 10 %
Scenario B: 6% (50000/120000) + 10% (70000 / 100000) = 8.33%
There are three points to be noted here.
- As the cost of capital decreases the value of the firm would go up as it is dependent
upon the return expected and the cost of capital. Inverse relationship exists between
the value of the firm and cost of capital for any given level of return.
Scenario A Scenario B
Equity 1,00,000 50,000
Debt 0 50,000
Cost of equity 10% 10%
Cost of debt 6% 6%Net operating income 10,000 10,000
Interest on debt 0 3,000
Equity earnings 10,000 7,000Market value of equity 1,00,000 70,000
Market value of debt 0 50,000
Total value of firm 1,00,000 1,20,000