After a study of the capital market he gathers the following data:

QUESTION

Kelley Manufacturing Co. has a total capitalization of Rs. 1,000,000, and it normally earns Rs 100,000 (before interest and taxes). The financial manager of the firm wants to take a decision regarding the capital structure. After a study of the capital market, he gathers the following data:(a) What amount of debt should be employed by the firm if the traditional approach is held valid?(b) If the Modigliani-Miller approach is followed, what should be the equity capitalisation rate? Assume that corporate taxes do not exist, and that the firm always maintains its capital structure at book values.Amount of Debt RsInterest Rate%Equity Capitalisation Rate % (at given level of debt)010100,000410.5200,000411300,0004.511.6400,000512.4500,0005.513.5600,000616700,000820
Solution: ( a ) As per the traditional approach, optimum capital structure exists when the weighted average cost of capital is minimum. The weighted average cost of capital calculations at book value weights are as follows: The firm should employ debt of Rs 400,000 as the weighted average cost of capital is minimum at this level of debt. (b) According to the M-M approach, the cost of capital is a constant, and the cost of equity increases linearly with debt. The equilibrium cost of capital is assumed to be equal to pure equity capitalisation rate, which is 10 per cent in the present problem. The equity capitalisation rate is given by the following

rmula: ke (1) we (2) kd (3) wd (4) ke we (5) kd wd (6) K0 (7) = (5) + (6) 0.1 1 0.1 0.1 0.105 0.9 0.04 0.1 0.0945 0.004 0.0985 0.11 0.8 0.04 0.2 0.088 0.008 0.096 0.116 0.7 0.045 0.3 0.0812 0.0135 0.0947 0.124 0.6 0.05 0.4 0.0744 0.02 0.0944 0.135 0.5 0.055 0.5 0.0675 0.0275 0.095 0.16 0.4 0.06 0.6 0.064 0.036 0.1 0.2 0.3 0.08 0.7 0.06 0.056 0.116 The equity capitalisation rates are shown in the following table.

ANSWER:

CLICK REQUEST FOR  AN EXPERT SOLUTION