19.46 Financial Management 8. Signaling theory states that investors see issue of debt as a good news. 9. Since interest on debentures is allowed to be deducted while calculating taxable income, interest « tax rate is a tax saving, 10. Usually issue of debt leads to emergence of agency costs; in the present context, debt is just one- third of equity, therefore, itis believed agency costs are not likely to arise. 11. Given sound capital structure ratios, firm's security rating is not expected to deteriorate (subsequent to raising of debt). 12. Given firm's credentials and market conditions, ssuance of either or both of debt and equity are likely to succeed REVIEW QUESTIONS LOD: Easy RQ.A9.L Provide the appropriate answers to the following: @ According to NI approach capital structure decision is to the valuation of the firm, (Grolevant/irrelevant) GD Market price per share if more debt is used in NI approach. (increases/decreases/ remains unchanged) Gi) According to NOL approach, cost of equity is —__ Gv) _____ implies buying securities in a market where price is low and selling where it is high: () In the traditional approach, the cost of equity is independent of amount of debe. (Truc/False) (WD In practice, equity financing allows firm to go for cheaper sources of ralse) (ii) What is the value of a levered firm Lif it has the same EBIT as an unlevered firm U, (with, value of $700 lakh), has a debt of €200 lakh, tax rite is 35 per cent uncer MM approach? (@) 2770 lakh b) 7500 lakh () 2630 lakh, (@) 00 lakh (Will) Whar is the value of an unlevered firm U if it has the same EBIT as a levered firm 1, (with, value of 2700 lakh), has a debt of 2200 lakh, tax rate of 35 per cent under MM approach? (@) 2770 lakh (b) 2500 Lakh, (©) 2630 Lakh, @ 2900 Lakh Gx) According to the traditional approach, what is the effect of increase in degree of leverage on the valuation of the firm? G) Increase (b) Decreases ©) Remains Unaffected (@) Increases first and then decreases ) According to NOI approach, with increase in debt/equity ratio the financial risk of equityholders nce in future. (True/ G) decreases (b) increases (©) no Change (@) depends on degree of levera [Answers: (i) Relevant (ii) Increases (iii) Residual (iv) Arbitrage process (v) False (vi) True (vii) 2770 lakh (viii) 7630 lakh (ix) Increase first then decreases and (x) Increases] RQ.19.2 What is meant by the concept financial risk’? What is the relationship between leverage and the cost of capital’ Explain, RQ.19.3. State the order in which firms will obtain financing under the pecking-order theory. Also state, in brief, the rationale for the order. RQ19-4 Companies U and L are identical in every respect except that the former does not use debt in its capital structure, while the latter employs %6 lakh of 15 per cent debt, Assuming that, (a) all the MM. assumptions are met, (b) the corporate tax rate is 35 per cent, (¢) the EBIT is %2,00,000, and (a) the ‘equity capitalisation of the unlevered company is 20 per cent, what will be the value of the firms, Uand 12 Also, determine the weighted average cost of capital for both the finns,