Agnes' Jam and Marmalade (AJM) is an all equity financed, family owned business operating

in a country where there are no corporate taxes. The company is expected to have a perpetual

EBIT of $2.1 million forever. With its current capital structure, the company has 500,000 shares

of common stock outstanding. Mr. Gru, the owner manager of the company, has talked its bank

and learnt that his company can safely borrow up to $6 million from the bank at an interest rate

of 10%.

a. Mr. Gru, the owner of the company tries to determine whether it is better for the company

to stay as an all equity financed firm or part debt part, equity financed firm. Given the EBIT

of the company, please help Mr. Gru with this decision and show him which capital

structure is better for the company.

b. Mr. Gru talked to some security analysts and learnt that the equity beta is 0.9 for all equity

financed firms like his operating in the same industry. The analysts also told Mr. Gru that

the risk free rate of return and the market return are 5% and 15%, respectively. Given this

information, calculate the unlevered cost of equity for the AJM.

c. Determine the value of the firm given its all equity financed capital structure.

d. Calculate the value of the firm if Mr. Gru decides to borrow $6 million from the bank.

Determine the capital structure weights the company will have after borrowing from the

bank.

e. Calculate the cost of equity and the weighted average cost of capital for the levered firm.

f. Suppose the country in which the AJM is operating in decides to institute a corporate tax

rate of 25% starting from today. Given this change in corporate tax rate, determine the

value of the AJM Company when the company has $6 million of debt.

g. Given this firm value, determine the capital structure weights for the company.

h. Suppose Mr. Gru wants to maintain the capital structure weights the company had before

the institution of corporate taxes in the country. Briefly explain to Mr. Gru what he needs

to do to achieve that capital structure.

i. Calculate the cost of equity and the weighted average cost of capital for the AJM Company.

Briefly compare and contrast the cost of equity and the weighted average cost of capital

for the levered AJM Company with and without taxes