RIFT VALLEY UNIVERSITY BURAYU CAMPUS

FACULITY OF BUSINESS AND ECONOMICS

DEPARMENT OF MANAGEMEN

COURSE: FINANCIAL MANAGEMENT I FOR 1st SEMESTER

GROUP ASSIGNMENT

Name. ID No
1)HANA WAGARI ,,,,,,,,,,,,,,,
1. XYZ expects a net operating income of Rs. 2, 00,000. It has 8, 00,000, 6% debentures.
The overall capitalization rate is 10%. Calculate the value of the firm and the equity
Capitalization rate (Cost of Equity) according to the net operating income approach. If the Debentures
debt is increased to Rs. 10, 00,000. What will be the effect on volume of the firm and the equity
capitalization rate?

SOLUTION
The value of the firm can be calculated
using the formula:
Value of the firm = Net operating
income / Capitalization rate
Value of the firm = 2,00,000 / 0.10 = Rs.
20,00,000

The equity capitalization rate (Cost of

Equity) can be calculated using the
formula:
Equity capitalization rate =
Capitalization rate - (Debenture interest
rate * (1 - Tax rate))
Equity capitalization rate = 0.10 - (0.06 *
(1 - 0)) = 0.10 - 0.06 = 0.04 or 4%

If the debenture debt is increased to Rs.

10,00,000, the value of the firm will
decrease and the equity capitalization
rate will increase.

This is because increasing the debenture

debt will increase the financial risk of the
firm, leading to a higher cost of equity for
the shareholders. As a result, the equity
capitalization rate will increase and the
value of the firm will decrease.

In summary, increasing the debenture

debt will have a negative impact on the
value of the firm and will lead to a higher
cost of equity for the shareholders.
2. Nile Company Ltd. expresses a net operating income of Rs. 2, 00,000. It has Rs. 8, 00,000 to 7%
debentures. The overall capitalization rate is 10%.
(a) Calculate the value of the firm and the equity capitalization rate (or) cost of equity according to the
net operating income approach

SOLUTION
(a)
Value of the firm = Net operating
income / Capitalization rate
Value of the firm = 2,00,000 / 0.10 = Rs.
20,00,000

Equity capitalization rate =

Capitalization rate - (Debenture interest
rate * (1 - Tax rate))
Equity capitalization rate = 0.10 - (0.07 *
(1 - 0)) = 0.10 - 0.07 = 0.03 or 3%
(b) If the debenture debt is increased to Rs. 12, 00,000. What will be the effect on the value of the firm,
the equity capitalization rate?

SOLUTION

(b)

If the debenture debt is increased to Rs.

12,00,000, the value of the firm will
decrease and the equity capitalization rate
will increase.

The new value of the firm can be calculated

as:

Value of the firm = 2,00,000 / 0.10 = Rs.

16,00,000

The new equity capitalization rate can be

calculated as:

Equity capitalization rate = 0.10 - (0.07 * (1

- 0)) = 0.10 - 0.07 = 0.03 or 3%
In summary, increasing the debenture debt
to Rs. 12,00,000 will decrease the value of
the firm and increase the equity
capitalization rate.
3. A Company expects a net income of Rs. 1, 00,000. It has Rs. 2, 50,000, 8% debentures. The equality
capitalization rate of the company is 10%. Calculate the value of the firm and overall capitalization rate
according to the net income approach (ignoring income tax). (c) If the debenture debts are increased to
Rs. 4, 00,000. What shall be the value of the firm and the overall capitalization rate?

SOLUTION
(c)

Using the net income approach, the value of

the firm can be calculated as:
Value of the firm = Net income / Equity
capitalization rate
Value of the firm = 1,00,000 / 0.10 = Rs.
10,00,000

The overall capitalization rate can be

calculated as:
Overall capitalization rate = Net income /
Value of the firm
Overall capitalization rate = 1,00,000 /
10,00,000 = 0.10 or 10%

If the debenture debts are increased to Rs.

4,00,000, the new value of the firm can be
calculated as:
Value of the firm = Net income / Equity
capitalization rate
Value of the firm = 1,00,000 / 0.10 = Rs.
8,33,333.33

The new overall capitalization rate can be

calculated as:
Overall capitalization rate = Net income /
Value of the firm
Overall capitalization rate = 1,00,000 /
8,33,333.33 = 0.12 or 12%

In summary, if the debenture debts are

increased to Rs. 4,00,000, the value of the
firm will decrease and the overall
capitalization rate will increase.