Furbo Plc:

Furbo Plc$.$ is an all$-$equity company with an equilibrium market value of $15$ million and a cost of capital of $20\%$ per year. The company$$s expected level of earnings before interest and tax is $5$ million per year. As all profits are paid out as dividends, the level of earnings is expected to remain constant in perpetuity. Corporate taxes are payable on earnings after interest expense at a rate of $40\%.$

The company proposes to change its capital structure by repurchasing $($and cancelling$)5$ million of equity and replacing it with $10\%$ perpetual debentures, issued at par.

Required:

$($a$)$ Using the assumptions and propositions of Modigliani and Miller $($adjusted for Corporate Taxes$),$ show how this change in capital structure will effect:

The company's market value;

The company's cost of equity;

The company's overall cost of capital.

$(10$ Marks$)$

$($b$)$ Assume that Furbo Plc has $1,700,000$ issued shares before the planned capital structure change, and plans to repurchase and cancel $500,000$ shares with the proceeds of the debt issue. Using EBIT$-$EPS analysis, determine the level of EBIT which would result in the same level of EPS irrespective of whether or not the company changes its capital structure. On this basis, identify which capital structure is likely to maximise earnings per share.

$(8$ Marks$)$

$($c$)$ Explain the possible signalling effects of the proposed change in capital structure.

$(7$ Marks$)$