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 Rs
|
Interest Rate%
|
Equity Capitalisation Rate % (at given level of debt)
|
|
0
|
-
|
10
|
|
100,000
|
4
|
10.5
|
|
200,000
|
4
|
11
|
|
300,000
|
4.5
|
11.6
|
|
400,000
|
5
|
12.4
|
|
500,000
|
5.5
|
13.5
|
|
600,000
|
6
|
16
|
|
700,000
|
8
|
20
|