LS0863: A company’s current earnings before interest and taxes are Rs 4,00,000. The firm currently has outstanding Rs 15 lakh of debts at an average cost of 10 per cent. Its cost of equity capital is estimated to equal 16 per cent

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Question: A company’s current earnings before interest and taxes are Rs 4,00,000. The firm currently has outstanding Rs 15 lakh of debts at an average cost of 10 per cent. Its cost of equity capital is estimated to equal 16 per cent.

a. Determine the current value of the firm using the traditional valuation Approach, the firm’s overall capitalization rate and leverage ratio

b. The firm is considering reducing its leverage by selling Rs 5 lakh of equity in order to redeem a Rs 5 lakh debt. The cost of debt is expected to be unaffected. However, the firm’s cost of equity capital is to be reduced to 14 per cent due to decrease in financial risk. Would you recommend the proposed action?


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