A totally equity financed company with 10 000 outstanding ordinary shares, each with a book value equal to market value of $35, is in the process of introducing debt into its capital structure. Funds raised through debt will be used to retire some of the shares and the company’s aim is to maintain the same total amount of financing. The company pays all its earnings as dividends and is subject to a 29% tax rate. The expected sales are $530 000, fixed costs are estimated at $251 000 and variable costs are estimated at 30% of sales.
The following capital structures are being considered:
Capital structure A at 40% debt ratio :A loan provided by Bank A at 20% per annum interest rate.
Capital structure B at 50% debt ratio : A loan provided by Bank B at 18% per annum interest rate.
QUESTIONS:
a) Calculate the number of shares to be purchased under each proposed capital structure.
b) Calculate the earnings per share for each proposed capital structure.
c) Calculate the weighted average cost of capital for each proposed capital structure.
d) Based on the value of the firm approach ( V=EBIT X(1-T)/WACC ), which capital structure would you advise the company to choose if its objective is to maximise its value?