The market value of a company is $32.5 million and its cost of capital is 18% per year. The company proposes to repurchase $5 million of equity and replace it with 13% irredeemable loan stock. The company’s earnings before interest and tax are expected to be constant for the foreseeable future.
Required:
A. Using the assumptions of Modigliani and Miller (1958) discuss and demonstrate how this change in the capital structure will affect the value of the company’s:
- Cost of Equity
- Cost of Capital
- Market Value
B. using the assumptions of Modigliani and Miller (1961) discuss how the change in the capital structure will affect the value of the company. Assume a corporate tax of 35%?