NET INCOME APPRAOCH AND NET OPERATING INCOME APPROACH

Page No.6.67

45 . a. Company X and Y are in the same risk class and identical in all respects
except that company uses debt, while company Y does not. Levered company has
Rs. 9 lakh debentures, carrying 10% rate of interest Both companies earn 20%
before interest and taxes on their total assets of Rs.15 lakh. Assume perfect capital
markets, tax rate 50% and capitalisation rate 15% for an all equity company.
Ascertain the value of both companies under NI and NOI Approach.

Statement showing computation of firm under NI Approach

Particulars Firm X Firm Y

Levered firm Unlevered firm
EBIT 3,00,000 3,00,000
LESS Interest 90,000 ---
Earnings before tax 2,10,000 3,00,000
Tax @ 50% 1,05,000 1,50,000
Earnings available to equity 1,05,000 1,50,000
shareholders (NI)
Equity capitlisation rate Ke 15% 15%
Value of equity (S) 7,00,000 10,00,000
Value of debt (B) 9,00,000 -
Value of the firm (V) 16,00,000 10,00,000
Working Notes:

Calculation of EBIT
15,00,000x20%= 3,00,000
Calculation of interest
Company X – 9,00,000x10% = 90,000
Calculation of tax
X – 210000x50% = 1,05,000
Y – 3,00,000x50%=1,50,000
Value of equity (S)= NI /Ke
Company X- 1.05.000/15x100=7,00,000
Company Y – 1,50,000/15x100=10,00,000
45. (b) Companies M and N are identical in every respect expect that the former
does not use debt in its capital structure, while the latter employs Rs. 12,00,000 of
15% debt. Assuming that (a) corporate tax rate is 35%. (b) EBIT is 4,00,000 and
(c)the equity capitalisation of the unlevered company is 20% what will be the value
of both companies under NI and NOI approach?
Statement showing computation of firm under NI Approach
 NOI APPROACH
Value of company X (Geared Co,) under NOI Approach
Market value of equity +Market value of debt
Market value of Equity(S) = EBIT (100% - Tax)/cost of equity(ke)
=3,00,000(100%-50%)/15x100
=1,50,000/15x100=10,00,000
Market value of debt = Value of debt x taxrate
= 9,00,000x50% = 4,50,000
Total value of the firm = S+B
= 10,00,000+ 4,50,000 14,50,000
Value of company Y (ungeared company)
Value of the firm = Market value of equity only
Market value of equity = EBIT (100%-Tax rate)/cost of equity
= 3,00,000(100%-50%)/15x100
=1,50,000/15x100=10,00,000
Value of the firm Y = 10,00,000
45. (b) Companies M and N are identical in every respect expect that the former
does not use debt in its capital structure, while the latter employs Rs. 12,00,000 of
15% debt. Assuming that (a) corporate tax rate is 35%. (b) EBIT is 4,00,000 and
(c)the equity capitalisation of the unlevered company is 20% what will be the value
of both companies under NI and NOI approach?
Statement showing computation of firm under NI Approach

Particulars Firm M Firm N

Unlevered firm Levered firm
EBIT 4,00,000 4,00,000
LESS Interest - 180000
Earnings before tax 4,00,000 2,20,000
Tax @ 35% 1,40,000 77,000
Earnings available to equity 2,60,000 1,43,000
shareholders (NI)
Equity capitlisation rate Ke 20% 20%
Value of equity (S) 13,00,000 7,15,000
Value of debt (B) - 12,00,000
Value of the firm (V) 13,00,000 19,15,000
Working Notes:

Calculation of interest
Firm M – 1,20,0000x15%=180000
Calculation of tax
M – 4,00,000X35%= 1,40,000
N – 2,20,000X35%=77,000
Value of equity (S)= NI /Ke
M-2,60,000/20X100=13,00,000
N-1,43,000/20X100=7,15,000

NOI APPROACH

Value of company M (UNLEVERED CO) under NOI Approach

Market value of the firm – Market value of equity
Market value of equity = EBIT (100%- Tax rate)/ke
=4,00,000 (100%-35%)/20%
= 4,00,000 (65%)/20x100
 =26,00,00/20x100=13,00,000
Value of the firm= 13,00,000

Value of levered firm N

Market value of the firm V= S+B
Market value of equity = EBIT (100%- Tax rate)/ke
=4,00,000 (100%-35%)/20%
= 4,00,000 (65%)/20x100
=26,00,00/20x100=13,00,000
Value of Debt = Debt x tax rate
=12,00,000x35%=4,20,000
Value of the firm = S+B
= 13,00,000+4,20,000= 17,20,000