12 Capital Structure. The finance director of Netra plc, a company listed on the AIM

(Alternative Investment Market) wishes to estimate what impact the introduction of debt finance is likely to have on the company’s overall cost of capital. The company is financed only by equity.

Netra plc Summarised Capital Structure

£000 Ordinary shares (25 pence par value) 500 Reserves 1,100 1,600 The company’s current share price is 420 pence, and up to £4 million of fixed rate five year debt could be raised at an interest rate of 10% per annum. The corporate tax rate is 33%.

Netra’s current earnings before interest and tax are £2.5 million. These earnings are not expected to change significantly in the foreseeable future.

The company is considering raising either:

(i) £2 million in debt finance or

(ii) £4 million in debt finance In either case the debt finance will be used to repurchase ordinary shares.

Required:

(a) Using Modigliani and Miller’s model in a world with corporate tax, estimate the impact on Netra’s cost of capital of raising:

(i) £2 million and

(ii) £4 million in debt finance.

State clearly any assumptions that you make.

(b) Briefly discuss whether or not the estimates produced in part

(a) are likely to be accurate.