Merlot plc is financed by 10m shares, whose current market value is £2.40 a share, and 10 per cent debentures with a nominal and market value of £14m. The business plans to issue additional shares to raise £14m and to use the cash generated to pay off the debentures. The corporation tax rate is 30 per cent.

(a) Making Modigliani and Miller’s assumptions (in a world with taxes), how would the restructuring described affect the value of the business?

(b) If the shareholders gain, who will lose, or if the shareholders lose, who will gain?