Problem
Consider the case of Dan Harris, Chief Financial Officer (CFO) of Electronic Business Services (EBS), who has been looking at possibilities for a major expansion of the company. To achieve this, EBS plans to raise $50 million from outside investors. One possibility is to raise the funds by selling EBS shares. Because of the risk to the company, Dan estimates that those who invest capital will require a risk premium of 10%, above the risk-free interest rate of 5%. That is, the cost of equity of the company is 15%. However, some senior EBS executives have claimed that instead of carrying out Following Dan's proposal, the company should consider borrowing $50 million. EBS has not borrowed before and, given its favorable balance sheet, it should borrow at an interest rate of 6%.
• Does the low interest rate on the debt make getting the loan a better financing choice for EBS?
• If the company borrows the money, will this affect the NPV of the expansion and thus change the value of the company and its share price?