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The solution is given below −

Interest cost = 12% (250000) = 30000/- Earnings = EBIT – Interest cost = 50000 – 30000 = 20000/- (no tax rate) Shareholders earnings = earnings Shareholders earnings = 20000/- Market value (equity) E = shareholder’s earnings/ cost of equity Market value (equity) E = 20000/16%= 125000 Market value (Debt) D = 250000/- Market value (total) = E + D Market value (total) = 125000 + 250000= 375000/- Cost of capital = EBIT/ market value (total) Cost of capital = 50000/ 37500 = 13.33% Degree of financial leverage = market value (debt)/ market value (total) Degree of financial leverage = 250000/ 375000= 66.67%

Now, if debt increases from 250000 to 300000

Interest cost = 12% (250000) = 30000/-

Earnings = EBIT – Interest cost = 50000 – 30000 = 20000/- (no tax rate)

Shareholders earnings = 20000/-

Market value (equity) E = 125000

Market value (Debt) D = 300000/-

Market value (total) = E + D = 125000 + 300000 = 425000/-

Cost of capital = EBIT/ market value (total) = 50000/ 425000 = 11.76%

Degree of financial leverage = market value (debt)/ market value (total) = 250000/ 425000 = 58.82%

From above two cases, we can conclude that if there is an increase in debt, there will be an increase in value of firm and decrease in cost of capital.

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