Assume you have been appointed as a business manager of Gills Food City located adjacent to University of Kelaniya. The company's EBIT was Rs. 5,000,000 in the last year, and due to the current pandemic, the university's enrollment is temporary stopped, thus, EBIT is expected to remain constant (in real terms) over time. Since no expansion capital will be required, Gills Food City plans to pay out all earnings as dividends. The management group owns about 50 percent of the stock.

The firm is currently financed with all equity; it has 100,000 shares outstanding; and Po=Rs.25 per share. When you took your MBA corporate finance course, your instructor stated that most firms owners would be financially better off if the firms used some debt. When you suggested this to your new boss, he encouraged you to pursue the idea. As a first step, assume that you obtained from the firm's investment banker the following estimated costs of debt for the firm at different debt levels (in thousands of Rupees).

Percentage Financed		Cost of Debt
with debt, wd		rd
0%		0.0%
20%		8.0%
30%		8.5%
40%		10.0%
50%		12.0%

If the company were to recapitalize, debt would be issued, and the funds received would be used to repurchase stock. Gills Food City is in the 24% tax bracket, the risk-free rate is 6 percent, and the market risk premium is 6 percent.

Required,

Q01

Illustrate whether changing the capital structure of Gills Food City can lead to a reduction in its cost of capital and hence to an increase in the value of the company. Be sure to identify the ways in which capital structure can affect the weighted average cost of capital and free cash flows.