Barry Barns Ltd (Barry) is a manufacturing company that has been financed with 20% debt in the form of a bank loan. The loan has a principal of $500,000, a 15-year term and a quoted interest rate of 4.8% p.a compounding annually. Interest is paid by the end of the year.

The company is considering applying for a new bank loan to finance a new project. The loan has a principal of $150,000; a 10-year term with a quoted rate of 4.5% p.a., and interest is paid annually.

Barrys before-taxed WACC (cost of asset) is currently 12% and companys tax rate is 30%

The manager has asked you to analyse the impact of the new borrowing on the capital structure, cost of capital and companys value.

Required

1. Calculate Barrys costs of equity BEFORE and AFTER the new debt issuance
2. Calculate the present value of interest tax shield (ITS) from the borrowing given the tax rate is 30% BEFORE and AFTER. Please note to discount the ITS by the cost of debt.
3. Comment on the following statement:

With interest tax shield, debts exhibit favourable impact on companys return on equity without cost

Do you agree or disagree? Why?

Identify at least three costs associated with an increase in debt level that adversely affects return on equity.