Traditional Approach As D: E ratio increases a cost of equity ks increases cost of debt ka may eventually Increasel a overall cost of capital k first decreases but then increases: a market value maximised and waco minimised at ocs
Traditional Approach As D:E ratio increases: ◼ cost of equity ks increases; ◼ cost of debt kd may eventually increase; ◼ overall cost of capital k first decreases but then increases; ◼ market value maximised and WACC minimised at OCS
Traditional Approach Example ti a company has $5 000 of 10% debt(Mv face value) a There are 3 000 shares issued(n =3 000) ks=15% a Earnings before interest per year =$5 000 a Calculate cost of capital, market value, and market value per share
Traditional Approach Example ◼ A company has $5 000 of 10% debt (MV @ face value). ◼ There are 3 000 shares issued (n = 3 000). ◼ ks = 15%. ◼ Earnings before interest per year = $5 000. ◼ Calculate cost of capital, market value, and market value per share
Earnings per year s5000 Less Interest($5000 X 10%) 500 Earnings available for equity 4500 Cost of equity(ks 0.15 Market value of equity 30000 Plus market value of debt 5000 Market value of firm S35000 Cost of Capital= Earnings/Market Value of firm S5000S35000 14.29 MV Per Share= MV of equity/No of Shares s30000/3000 s10
Earnings per year $ 5000 Less Interest ($5 000 × 10%) 500 Earnings available for equity 4500 Cost of equity (ks ) 0.15 Market value of equity 30000 Plus Market value of debt 5000 Market value of firm $35000 Cost of Capital = Earnings/Market Value of Firm = $5000/$35000 14.29% MV Per Share = MV of Equity/No. of Shares = $30000/3000 $10
A Variation a Suppose $5 000 more debt 10% is issued to replace equity, with debt proceeds used to repurchase 500 $10 shares leaving 2 500 shares issued As a result of increased gearing k increases to 20%to compensate investors for greater financial risk
A Variation ◼ Suppose $5 000 more debt @ 10% is issued to replace equity, with debt proceeds used to repurchase 500 $10 shares, leaving 2 500 shares issued. ◼ As a result of increased gearing, ks increases to 20% to compensate investors for greater financial risk
Earnings per year s5000 Less Interest(S10 000 X 10%) 1000 Earnings available for equity 4000 Cost of equity(ks 0.20 Market value of equity 20000 Plus market value of debt 10000 Market value of firm S30000 Cost of Capital Earnings/Market value S5000S30000 16.67% MV Per Share= Mv of equity/No of Shares s20000/2500 S8
Earnings per year $ 5000 Less Interest ($10 000 × 10%) 1000 Earnings available for equity 4000 Cost of equity (ks ) 0.20 Market value of equity 20000 Plus Market value of debt 10000 Market value of firm $30000 Cost of Capital = Earnings/Market Value = $5000/$30000 16.67% MV Per Share = MV of Equity/No. of Shares = $20000/2500 $8