Company XYZ is unlevered and has a cost of equity of 20 percent and a total market value of 10,00,00,000. Company ABC is identical to XYZ in all…

CA Intermediate · Financial Management and Strategic Management · RTP · September 2024
Company XYZ is unlevered and has a cost of equity of 20 percent and a total market value of 10,00,00,000. Company ABC is identical to XYZ in all respects except that it uses debt finance in its capital structure with a market value of 4,00,00,000 and a cost of 10 percent. FIND the market value of equity, weighted average cost of capital and cost of equity of ABC if the tax advantage of debt is 25 percent.

Suggested Answer and Working Notes:

Computation of Market Value of Equity of Company ABC Total market value of Company ABC VABC = VXYZ + Bt............. (i) Where, VABC = Market value of leveraged company. VXYZ = Market value of unleveraged company. B = Market value of debt. t = Tax rate. Now, given VXYZ = 10,00,00,000 B = 4,00,00,000 t = 25% By substituting values in equation (i) above, we have VABC = 10,00,00,000 +4,00,00,000 × 0.25 VABC = 11,00,00,000 The Market Value of Equity (s) of Company ABC, S = VABC – B S = 11,00,00,000 - 4,00,00,000 S = 7,00,00,000 Weighted Average Cost of Capital of Company ABC WACCABC = WACCXYZ [1- Bt/VABC] WACCABC = 20% [1 - (₹ 4,00,00,000 /11,00,00,000) × 0.25] WACCABC = 20% [1 - 0.0909] WACCABC = 20% [0.9091] = 18.18% Cost of Equity of company ABC REABC = REXYZ + [(1 - t)B/E(REXYZ - RB)] REABC = 20% + [(1 - 0.25) ₹ 4,00,00,000 /7,00,00,000 (0.20 - 0.10)] REABC = 20% + [0.75 × 4/7 × 0.10] REABC = 20% + [0.42857 × 0.10] REABC = 20% + 4.2857% = 24.2857% approx.

Topics: Part-A: Financial Management

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