Company Y is yet another company which is currently financed only by the Equity capital.

Y is operating in the same industry as that of X. It’s summarized Capital structure is as follows:

                                                                                                            $

Ordinary shares ($0.25 par value) …………………………….. 1,000,000

Reserve ……………………………..............…………………………... 1,250,000

                                                                                                  2,500,000

Y’s current share price is $2.50 per Ordinary Share. Up to $5 million of fixed rate five years debt could be raised by Y at an interest rate of 8% per annum. The corporate tax rate is 25%.

Y’s current earnings before interest and tax are $1,500,000. These earnings are not expected to change significantly for the foreseeable future. 

The Company is considering raising $2 million in debt finance. The debt finance will be used to repurchase ordinary shares. 

Using Miller and Modigliani’s model in a world with corporate tax, estimate the following:

i. The market value of un-greased Company

ii. The cost of equity of un-greased Company 

iii. The market value of geared Company 

iv. Observe any change to the cost of equity by the introduction of debt capital and comment on the change.