Z Ltd. is an unlevered company. It wants to repurchase its equity shares of 300 lakhs by issue of 12% debentures of same amount. Current market…

Answer (b) Market Value of Equity Net income (NI) for equity holders = Net income (NI) for equity holders K e 1,400 lakhs = Net income (NI) for equity holders 0.18 Net Income to equity holders/EAT = 252 lakhs Therefore, EBIT = EAT (1-t) = 252 lakhs (1-0.3) = 360 lakhs Income Statement All Equity (₹ in lakhs) Equity & Debt (₹ in lakhs) EBIT (as calculated above) 360 360 Interest on 300 lakhs @ 12% - 36 EBT 360 324 Tax @ 30% 108 97.2 Income available to equity holders 252 226.8 (i) Market value of Z Ltd Market value of levered firm = Value of unlevered firm + Tax Advantage = 1,400 lakhs + (300lakhs x 0.3) = 1,490 lakhs Change in market value of the company = 1,490 lakhs – 1,400 lakhs = 90 lakhs The impact is that the market value of the company has increased by 90 lakhs due to replacement of equity with debt. (ii) Overall Cost of Capital Market Value of Equity = Market value of levered firm - Equity repurchased = 1,490 lakhs – 300lakhs = 1,190 lakhs Cost of Equity (K e ) = Net Income to equity holders Market value of equity × 100 = 226.8 lakhs 1190 lakhs × 100 = 19.06% (approx.) Cost of debt (K d ) = I (1 - t) = 12 (1 - 0.3) = 8.4% Components Amount (₹ in lakhs) Cost of Capital % Weight WACC (K o ) % Equity 1,190 19.06 0.80(approx.) 15.25 Debt 300 8.4 0.20(approx.) 1.68 1490 1 16.93 (Note: If we take the weight of Equity as 0.7986 and weight of Debt as 0.2013 then WACC will be 16.91%). Impact on Market value and Overall cost of capital of Z Ltd. Particulars Before restructure After restructure Impact Market value of company 1,400 lakhs 1,490 Lakhs Increase due to import of debt Cost of equity 18% 19.06% Increase Overall cost of capital 18% 16.93% Decrease So, the impact is that the Overall Cost of Capital or K o has fallen by 1.07% (18% - 16.93%) due to the benefit of tax relief on debt interest payment. (iii) Cost of Equity The impact is that cost of equity has risen by 1.06% (19.06% - 18%) due to the presence of financial risk i.e. introduction of debt in capital structure. Note: Cost of Capital and Cost of equity can also be calculated with the help of following formulas, Cost of Capital (K o ) = K eu [1 – (t x L)] Where, K eu = Cost of equity in an unlevered company t = Tax rate L = Debt Debt + Equity So, K o = 0.18 [1-(0.3 x 300 lakhs 1490 lakhs )] = 0.1691 or 16.91% (approx.) Cost of Equity (K e ) = K eu + (K eu - K d ) Debt (1-t) Equity Where, K eu = Cost of equity in an unlevered company K d = Cost of debt t = Tax rate So, K e = 0.18 + ((0.18-0.12) × 300 lakhs (1-0.3) 1190 lakhs ) = 0.1906 or 19.06%