Arrange the logical steps under the Net Income (IN) approach of capital structure : A. Increase in financial leverage reduces the overall cost of capital. B. Reduced overall cost of capital increases the value of the firm. C. Assumes cost of equity and cost of debt remain constant. D. Concludes that value of firm can be maximized by using as much debt as possible. Choose the correct answer from the options given below :
C, A, B, D
The correct sequence is C, A, B, D — option 1.
The chain of reasoning. The Net Income approach, associated with David Durand, is a short argument in which each step depends on the one before :
| Order | Step | Role in the argument |
|---|---|---|
| 1 | C — Assume the cost of equity (Ke) and the cost of debt (Kd) stay constant | The assumption — every argument begins with its premises. Crucially, shareholders are assumed not to demand a higher return as debt rises |
| 2 | A — More leverage lowers the overall cost of capital (Ko) | The first consequence. Since Kd < Ke and neither changes, replacing costly equity with cheap debt must pull the weighted average down |
| 3 | B — A lower Ko raises the value of the firm | The second consequence — value is operating income capitalised at Ko, so a smaller denominator gives a larger value |
| 4 | D — Therefore use as much debt as possible | The conclusion |
The valuation.
\(V=\dfrac{\text{EBIT}}{K_{o}},\qquad K_{o}=K_{e}\dfrac{E}{V}+K_{d}\dfrac{D}{V}\)
On the assumption in C, the second expression falls as D/V rises, and the first therefore increases. The optimum capital structure is thus 100 per cent debt — the theoretical extreme at which the value of the firm is greatest.
How to place the steps without knowing the theory. Assumptions come first and conclusions last, so C must open and D must close. That alone identifies option 1.
The criticism. The assumption in C is the weak point: as debt rises, so does financial risk, and shareholders do demand a higher return. That is exactly what the rival Net Operating Income approach asserts — Ke rises just enough to offset the cheaper debt, Ko stays constant, and capital structure is irrelevant. Modigliani and Miller proved that irrelevance formally under perfect markets, and then showed that with corporate tax the interest shield does make debt valuable. The traditional view sits between: an optimum exists at moderate leverage, beyond which the rising cost of financial distress outweighs the tax shield.
Hence, the answer is C, A, B, D.
Similar Questions
A public works project is proposed that has total present-worth benefits of ₹ 75 million and total present-worth cost of ₹ 55 million. In deliberating this proposal, some members of the Municipal Board have suggested that the project has a total present-worth disbenefits of ₹ 15 million; other members feel that ₹ 15 million should be treated as a cost. What will be the benefit cost ratio and net benefits value while considering the disbenefits as a cost?
Select the correct statement/s from the following :
Statement I : The slope of the NPV profile reflects how sensitive the project is to discount rate changes.
Statement II : To find total NPV of more than one projects, their NPV cannot be added.
Statement III : The certainty equivalent coefficient applies adjustments to both, the cash flows (in the numerator) and the discount factor (in the denominator).
Statement IV : The risk - adjusted discount factor applies adjustment for risk only to the discount factor (denominator).
Codes :
Indicate the correct code of the combinations of the following methods commonly used for capital budgeting:
a. Payback Period
b. Profitability Index
c. Utility theory
d. Internal rate of return
Codes:
NPV and IRR methods of investment evaluation may give divergent accept-reject decisions on account of which of the following?
a. Varying initial investment
b. Divergent cash flows from the investment projects
c. Disparity in the lives of the investment projects
Indicate the correct code of their combinations.
Codes:
The capital budgeting appraisal criterion that is most appropriate in the situation of capital rationing will be:
For computation of cost of equity, arrange the following measures in the ascending order of accuracy:
I. Capital Asset Pricing Model
II. Dividend-Price Ratio
III. Earning-Price Ratio
IV. Dividend-Price Plus Growth Ratio
Which of the following are the assumptions of Modigliani and Miller’s Dividend Irrelavance Theory ?
A. Perfect Capital Market
B. No taxes
C. No transaction Cost and no time lag
D. Fixed Investment Policy
E. Investors behave irrationally
Choose the correct answer from the options given below :
Match the correct options for the following capital budgeting appraisal criteria:
List - I List - II a. The criterion based on the cash flows of a limited period. i. Internal Rate of Return b. The criterion based on profit over life of the project. ii. Pay-back Method c. The criterion that considers cash flows over the life of project which considered the time value of money. iii. Accounting Rate of Return d. The criterion that derives the outcomes in terms of the rate of return considering the cash flows over the life of project with the time value of money. iv. Net Present Value A company issues 11% debentures of ₹ 100 each for an amount aggregating ₹ 2,00,000 at 10% premium, redeemable at par after 5 years. The company tax rate is 40%. The cost of debt is:
Given below are two statements : one is labelled as Assertion (A) and the other is labelled as Reason (R).
Assertion (A) : Liberal credit policies increase the probability of defaults and the associated bad debt losses.
Reason (R) : Relaxing credit standards will generally increase sales but may reduce the quality of receivables.
In the light of the above statements, choose the most appropriate answer from the options given below :
Important Questions from Capital Budgeting
A firm is currently earning Rs. 50,000 and its one share has a present market value of Rs. 175. It has 5,000 shares outstanding. The earnings of the firm is expected to remain stable and it has a payout ratio of 100%. The cost of equity is:
With project cost of ₹300 lacs, profits after depreciation (straight line method) and tax for its lifetime of 5 years are estimated at ₹10 lacs, ₹10 lacs, ₹30 lacs, ₹40 lacs and ₹50 lacs respectively. The cost of capital is 12% and discount factors @ 12%, for the first five years are 0.89, 0.80, 0.71, 0.64 and 0.57 respectively. The Net present value of project is :
Match List I with List II
LIST I
(Investment Decision rule)
LIST II
(Feature)
A. NPV I. Insufficiently consistent B. Payback II. Highly Inflexible C. Cash Returns III. Balance between flexibility and consistency D. Accounting Returns IV. Relatively consistent Choose the correct answer from the options given below:
If the Net Present Value (NPV) of an investment proposal is positive, what conclusions can be drawn?
A. The investment generated present value of cashflows exceed cost of investment
B. The discount rate used is less than the investments estimated return
C. The discount rate used equals the minimum return required by the investors
D. The investment generated present value of cashflows equals the cost of investment
E. The investment's Internal Rate of Return (IRR) exceeds the Cost of Capital
Choose the correct answer from the options given below:
Arrange (in descending order) the following present value of a growing perpetuity which makes first payment of Rs. 3,000 in next year.
A. Present value at 8% growth and 10% discount rate.
B. Present value at 3% growth and 9% discount rate.
C. Present value at 6% growth and 11% discount rate.
D. Present value at 5% growth and 6% discount rate.
E. Present value at 1% growth and 4% discount rate.
Choose the correct answer from the options given below
