ABC is a small manufacturer of surgical equipment. The company has grown rapidly. This growth has been funded by retained earnings and two share issues, enabling the company to retain an all-equity capital structure since it was listed on the ASX.

there's a proposal to change the companys capital structure to one with debt representing 30% of the value of the company. The directors, however, were not convinced that this would be in the best interests of long-term shareholders who had invested in the company partly on the basis of its business strategy and conservative financing policy.

The company currently has 1,000,000 shares outstanding, and the current market price is $5.00. EBIT is expected to be $4,000,000 and is forecast to remain stable indefinitely, given that future sales will largely be based on the purchase of replacement equipment. The interest rate on new debt is 7%. The company has just changed its dividend policy to one involving a payout rate of 100% that it plans to maintain indefinitely now its rapid growth phase is over.

Nana is a shareholder and director of the company with a holding of 100,000 shares. She is unhappy with the decision of her fellow directors. She believes that the use of debt by the company would create value for its shareholders since debt is usually cheaper than equity capital. New debt capital raised by the company could be used to buy back its shares, and provide a cash return to shareholders who have supported the past growth of the company and elect to take up the buyback offer.

In order to boost her arguments in support of a change in capital structure, Nana has sought your advice. She wants you to consider how she would benefit from the change in capital structure as an example to share with her fellow directors. Use Modigliani and Miller as a guide to the advice you would provide to Nana.

1. As a first step, consider the impact of a change in the debt ratio of the company from 0 to 30% on Nana's annual income from her shares assuming the company is not subject to company tax. Assume that Nana could invest any proceeds from re-purchase of her shares in an investment earning 7% per annum. What aspects of this analysis, if any, would you highlight in your report to Nana?

2. Now consider this change in capital structure in the context of the company being subject to company tax at the rate of 30%. What impact is this likely to have on Nana's income and the value of the company.?

3. What other issues should you bring to Nana's attention in your report?