Capital Structure Case Study - Star Star is a company which has recently been listed on the Alternative Investment Market. Its main business is developing new applications for the iphone and it is currently looking to develop a new application that allows players to throw wet sponges at various contemporary villains (politicians feature highly). This new application requires that 20m of new finance should be raised. Until now, the company have used simple methods of evaluating investments such as payback. However, now that they are listed, the recently newly appointed accountant believes that they should be considering a more scientific method of evaluating investment opportunities. He also believes that the capital structure should be considered as a tool for maximising shareholder value rather than just a way of getting money as easily as possible. The accountant, being a graduate of only a few years, can remember his old professor of finance explaining about theories developed by Modigliani and Miller and believes his employer can benefit from the insights that arise from these theories of capital structure.

The Star Company is financed using the following methods:

1. Equity. The company has 10 million shares, which are trading at 8.00 per share. It has an equity beta of 1.2.

2. Preference shares. Star has ten million 1 5% preference shares, which are trading at 0.90.

3. Debt. Star has 10m (at par value) of 10% debentures, which are redeemable at par in five years time. The debentures are currently trading at 105.

The return on the market is 8% per cent and risk free government gilts are currently trading at 3%. The corporate tax rate is 30 per cent.

The new accountant believes that adding substantial debt will be more beneficial than raising extra equity. However, the Chief Executive believes that the least debt the better and cannot see any merit in adding to what he already believes is too much debt.

Questions

1. Calculate the current WACC of the Star company.

2. Calculate the new WACC if the additional finance is raised using a) equity and b) debentures (assume all other figures remain the same). Advise the company on which method of finance to choose.

3. Discuss the merits of using equity versus debt when financing new investment in a company.