Question

A company has $ 200,000 as EBIT .It has $ 1,000,000, 10% debentures .The equity capitalization rate (Ke)of the company is 12.5%. Find out the value of the firm under Net Income Approach. Also prove the NI approach.

Accepted Answer

net income approach: company’s cost of capital changes with the debt-equity mix and search for the lowest value of the cost of capital, hence the maximum value of the firm (MBA Notes World)

Net income approach is one of three theoretical frameworks for how a company should proceed to set its debt-to-equity mix. The objective is to find the lowest value for the cost to capitalize (the cheapest source of debt-to-equity mix to fund the capitalization). The result is the highest maximum value to the company or firm (lowest cost of debt-to-equity capitalization = highest maximum value to the firm). the other two frameworks are the operating income approach and the traditional approach. Each framework reaches different conclusions thus framework selection is relevant to operations.

Answer

The company has $200,000 as Earnings before Interest and Tax or EBIT. It has 10% debentures with a face value $1000000.
The interest payable on the debentures is (10/100)*1000000 = $100000. As the rate of taxation is not provided, it is assumed that no tax is to be paid by the company. This gives the net income of the company as 200000 - 100000 = 100000.
The equity capital rate refers to the ratio of the net operating income and the market capitalization. Here, the equity capital rate is 12.5%. If M is the market capitalization 100000/M = 0.125 or M = 100000/0.125 = 800000
The value of the firm is $800000

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A company has $ 200,000 as EBIT .It has $ 1,000,000, 10% debentures .The equity capitalization rate (Ke)of the company is 12.5%. Find out the value of the firm under Net Income Approach. Also prove...

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