Zordon Ltd. has net operating income of 5,00,000 and total capitalization of 50,00,000 during the current year. The company is contemplating to…

(i) Amount of debt to be employed by firm as per traditional approach Calculation of Equity, W d and W e Total Capital (₹) Debt (₹) W d Equity value (₹) W e (a) (b) (b)/(a) (c) = (a) - (b) (c)/(a) 50,00,000 0 - 50,00,000 1.0 50,00,000 5,00,000 0.1 45,00,000 0.9 50,00,000 10,00,000 0.2 40,00,000 0.8 50,00,000 15,00,000 0.3 35,00,000 0.7 50,00,000 20,00,000 0.4 30,00,000 0.6 50,00,000 25,00,000 0.5 25,00,000 0.5 50,00,000 30,00,000 0.6 20,00,000 0.4 Statement of Weighted Average Cost of Capital (WACC) K e W e K d W d K e W e K d W d K o (1) (2) (3) (4) (5) = (1) x (2) (6) = (3) x (4) (7) = (5) + (6) 0.100 1.0 0.100 0.100 0.105 0.9 0.060 0.1 0.095 0.006 0.101 0.110 0.8 0.060 0.2 0.088 0.012 0.100 0.113 0.7 0.062 0.3 0.079 0.019 0.098 0.124 0.6 0.070 0.4 0.074 0.028 0.102 0.135 0.5 0.075 0.5 0.068 0.038 0.106 0.160 0.4 0.080 0.6 0.064 0.048 0.112 So, amount of Debt to be employed = 15,00,000 as WACC is minimum at this level of debt i.e. 9.8%. (ii) As per MM approach, cost of the capital (K o ) remains constant and cost of equity increases linearly with debt. Value of a firm = Net Operating Income (NOI) K o 50,00,000 = 5,00,000 K o K o = 5,00,000 50,00,000 = 10% Statement of Equity Capitalization rate (k e ) under MM approach Debt (₹) Equity (₹) Debt/Equity K o K d K o - K d K e = K o + (K o - K d ) Debt Equity (1) (2) (3) = (1)/(2) (4) (5) (6) = (4)-(5) (7) = (4) + (6) x (3) 0 50,00,000 0 0.10 - 0.100 0.100 5,00,000 45,00,000 0.11 0.10 0.060 0.040 0.104 10,00,000 40,00,000 0.25 0.10 0.060 0.040 0.110 15,00,000 35,00,000 0.43 0.10 0.062 0.038 0.116 20,00,000 30,00,000 0.67 0.10 0.070 0.030 0.120 25,00,000 25,00,000 1.00 0.10 0.075 0.025 0.125 30,00,000 20,00,000 1.50 0.10 0.080 0.020 0.130