Eastwell is to be established shortly as a partnership. The founders are considering their options with regard to capital structure. A total of £lm will be needed to establish the business and the three ways of raising these funds being considered are:
a. Selling 500,000 shares at £2.00.
b. Selling 300,000 shares at £2.00 and borrowing £400,000 with an interest rate of 12 per cent.
c. Selling 100,000 shares at £2.00 and borrowing £800,000 at an interest rate of 13 per cent.
There are three possible outcomes for the future annual cash flows before interest:

Required
a. Calculate the expected annual return to shareholders under each of the capital structures.
b. Calculate the standard deviation of the expected annual return under each of the capital structures.
c. Explain the terms 'business risk' and 'financial risk'.

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Success of product Cash flow before interest Probability Poor Good Excellent 60,000 £160,000 E300,000 0.25 0.50 0.25 Note Taxes may be ignored.