Model Answer
0 min readIntroduction
In financial management, determining the value of a firm is a fundamental exercise. This valuation is crucial for investment decisions, mergers and acquisitions, and overall strategic planning. The value of a firm is often assessed using its earning potential, specifically its Earnings Before Interest and Taxes (EBIT), and the cost of capital employed. Understanding the relationship between EBIT, debt, equity, and capitalization rates allows for a comprehensive assessment of a company’s worth. This answer will compute the market value of equity and the value of the firm for A Ltd., given its EBIT, debenture details, and equity capitalization rate.
Calculating the Cost of Debt (Kd)
First, we need to determine the cost of debt. The debentures have a face value of ₹30 lakhs and a coupon rate of 12%. Assuming debentures are issued at face value, the cost of debt (Kd) is equal to the coupon rate.
Kd = 12%
Calculating the Weighted Average Cost of Capital (WACC)
To calculate the WACC, we need to determine the weights of debt and equity in the capital structure. However, the question doesn't provide the market value of debt or equity directly. We will proceed by assuming the debenture value represents the debt portion and calculate the equity value based on the given capitalization rate.
We will use the following formula to calculate the value of the firm (V):
V = EBIT / Ke
Where:
- V = Value of the firm
- EBIT = Earnings Before Interest and Taxes
- Ke = Equity Capitalization Rate
Calculating the Value of the Firm (V)
Using the given data:
EBIT = ₹ 10,00,000
Ke = 20%
V = ₹ 10,00,000 / 0.20 = ₹ 50,00,000
Therefore, the value of the firm is ₹ 50,00,000.
Calculating the Market Value of Equity (E)
The market value of equity can be calculated by subtracting the market value of debt from the value of the firm.
E = V - D
Where:
- E = Market Value of Equity
- V = Value of the Firm
- D = Market Value of Debt
Assuming the debentures are held at face value, D = ₹ 30,00,000
E = ₹ 50,00,000 - ₹ 30,00,000 = ₹ 20,00,000
Therefore, the market value of equity is ₹ 20,00,000.
Summary of Results
| Item | Value (₹) |
|---|---|
| EBIT | 10,00,000 |
| Debenture Value (D) | 30,00,000 |
| Equity Capitalization Rate (Ke) | 20% |
| Value of Firm (V) | 50,00,000 |
| Market Value of Equity (E) | 20,00,000 |
Conclusion
In conclusion, based on the provided information and applying the principles of firm valuation, A Ltd.’s market value of equity is ₹ 20,00,000 and the value of the firm is ₹ 50,00,000. These calculations are based on the assumption that debentures are held at face value. A more precise valuation would require detailed information about the market values of both debt and equity, and a thorough analysis of the company’s risk profile. This exercise highlights the importance of understanding the interplay between profitability, capital structure, and cost of capital in determining a firm’s overall worth.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.