Market Price

Thus, according to the N1 Approach, the firm, can increase/decrease its total value (V) and lower/increase overall cost of capital (k) as it increases/decreases the degree of leverage. As a result, price per share is affected. To illustrate, assume in Example, that the firm with debt has 2,400 equity shares outstanding. The market price per share works out to (Rs 2,40,000 + 2,400). The firm issues Rs 1,00,000 additional debt and uses the proceeds of repurchase/retire Rs 1,00,000 worth of equity shares or 1,000 shares. It, then, has 1,400 outstanding. We have observed in Example, that the total market value of the equity change in the capital structure is Rs 1,60,000 Table. Therefore, the market price per 114.28 (Rs 1,60.000 + 1,400), as compared to the original price of Rs 100 per share. However, when the firm employs less amount of debt, the market value per share declines. To Example, the firm raises Rs 1,00.000 additional equity capital by issuing 1.000 of Rs 100 each and uses the proceeds to retire the debenture amounting to would then have Rs 3,400 shares (2,400 old + 1.000 new) outstanding. With this capital have seen in Example, that the total market value of equity shares is Rs 3.20,000. Therefore, the market price per share has declined to Rs 94.12 (Rs 3,20,000 + 3,400) before a change in the leverage.

We can graph the relationship between the various factors (ke, kr, ko) with the degree of leverage.

Leverage and Cost or Capital (N1 Approach)

Leverage and Cost or Capital (N1 Approach)

The degree of leverage (Bill) is plotted along the X-axis, while the percentage rates of ko are on the Y-axis. This graph is based on Example. Due to the assumptions that k1 remain unchanged as the degree of leverage changes, we find that both the curves are para the X-axis. But as the degree of leverage increases, k0 decreases and approaches the cost of when leverage is 1.0, that is, (k0 = k1). It will obviously be so, owing to the fact that there equity capital in the capital structure. At this point, the firm’s overall cost of capital would be minimum. The significant conclusion, therefore, of the N1 Approach is that the firm can almost 100 per cent debt to maximize its value.

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