Green Lawns Ltd sells one type of Lawnmower designed for domestic use at a selling price of $800 per unit. The purchase cost per unit is $550. The company has fixed operating costs of $84,000 per annum. The company expects to sell 500 units of this product in 2015.

Green Lawns Ltd has the following capital structure:

	$
Ordinary shares (par value $1)	300,000
6% Preference shares (par value $1)	150,000
Term loan (10% interest per annum)	250,000
	700,000

The corporate tax rate is 40%.

Required:

Calculate the degrees of operating leverage (DOL), financial leverage (DFL) and total leverage (DTL) at the expected sales level of 500 units.

Canalot Ltd is an all-equity company with a market value of $30 million and a cost of capital of 18% per year. The company is proposing to repurchase $5 million of equity and to replace with 13% irredeemable debt.

Canalots earnings before interest and tax are expected to be constant for the foreseeable future and all profits are paid out as dividends.

Required:

Assuming Canalot Ltd operates in an environment where there are no taxes and using the assumptions of Modigliani and Miller, Compute:

The cost of capital.

The cost of equity capital

If the company goes ahead with the proposal

Assuming Canalot Ltd has a marginal tax rate of 40% and using the assumptions of Modigliani and Miller, Compute:

The value of the company

The debt to equity ratio of the company

The new cost of equity capital

The revised weighted average cost of capital

If the company goes ahead with the proposal

How does the existence of financial distress costs and agency costs affect Modigliani and Miller theory in a world where corporations pay taxes?