The ordinary shares of Stanley plc are quoted on the London Stock Exchange. The directors, who are also major shareholders, have been evaluating some new investment opportunities. If they go ahead with these, new capital of £38 million will be required. The directors expect the new projects to earn 15 per cent per annum before tax.

Financial information about the company for 2017 is as follows:

EBIT (existing operations) £79.50 million Number of shares in issue (par value £1) 50 million The company is at present all-equity-financed. It has the choice of raising the £38 million new capital by an issue of equity or debt. Equity would be issued by a new issue at a 15 per cent discount to current market price. Debt will be raised by an issue at par of 12 per cent unsecured loan stock.

If the finance is raised via equity, the company’s P:E ratio is likely to rise from its current level of 9 to 9.5.
However, if debt is introduced into the capital structure, the company’s financial advisers have warned the two directors that the market is likely to lower the P:E ratio of the company to 8.5.
The company’s marginal tax rate is 33 per cent.
Issue costs should be ignored.

(a) Determine the expected share price, total value of equity and value of the firm under the two financing options and comment briefly on which financing option appears the most advantageous.

(b) Assume the company’s average cost of equity as an ungeared firm is 14 per cent and it expects to continue to pay tax at 33 per cent. The estimated cost of bankruptcy or financial distress is estimated at £5 million. According to Modigliani and Miller, what would be the value of equity and the firm if the company finances the expansion by (i) equity or (ii) debt?

(c) Explain the basic assumptions underlying MM’s theories of capital structure and why, in an efficient market with no taxes, capital structure can have no effect on the value of the firm.