2 The projected cash flows for a company to be established are 1m per year forever. The company will require 9m in capital to be viable and produce the 1m annual cash flows. The prospective directors suggest that they raise 2m by borrowing from a bank at a fixed rate of 6% per year. The remaining 7m will come from an issue of shares. Shares with a similar systematic risk are currently offering an expected return of 11%. This cautious level of borrowing suits the directors because their livelihood depends on the survival of the firm. The corporation tax rate is 30%. a Calculate the WACC and the value of the enterprise (debt + equity value). b If a higher level of financial gearing is targeted such that 5m of the capital comes from lenders and 4m comes from shareholders the required rates of return change. The debt holders now require 7% per annum, whereas the equity holders expect a return of 16% per year. Does this capital structure raise or lower the WACC and value of the firm?