Skip to content

CA Intermediate · Financial Management and Strategic Management · Financing Decisions - Capital Structure

Gomti Foods Ltd has EBIT of ₹6,00,000 and debt of ₹10,00,000 at 10% interest. Under the Net Income approach, its cost of equity is constant at 12.5% and cost of debt is constant. The firm issues further debt of ₹10,00,000 at the same 10% and uses the proceeds to buy back equity. Ignoring taxes, what is the value of the firm after the change?

The firm value becomes ₹52,00,000. With debt of ₹20,00,000 the interest is ₹2,00,000, so earnings to equity of ₹4,00,000 capitalised at 12.5% give equity of ₹32,00,000, and adding debt of ₹20,00,000 gives the total.

  1. A₹32,00,000
  2. B₹48,00,000
  3. C₹50,00,000
  4. D₹52,00,000Correct

Explanation

After the change, debt is ₹20,00,000 and interest is ₹2,00,000. Equity value = (6,00,000 − 2,00,000)/0.125 = ₹32,00,000. Firm value = 32,00,000 + 20,00,000 = ₹52,00,000. Check: the original firm value was ₹40,00,000 + ₹10,00,000 = ₹50,00,000, so value rises by ₹2,00,000. Option C is the earlier value, and option A is the equity value only.

Did you get it right without looking?

One question tells you little. A timed set on Financing Decisions - Capital Structure shows your real accuracy, how long you take and where you lose marks.

Practise Financing Decisions - Capital StructureFree diagnostic mock

More Financing Decisions - Capital Structure questions