Harris Manufacturing Company expects an EBIT of $87,000 every year forever. The firm currently has no debt, and its cost of equity is 14.6 percent. The firm can borrow at 7.4 percent and the corporate tax rate is 34 percent.

a) Use the appropriate M&M Proposition to compute (i) the current value of the firm and (ii) the value of the firm if it were to change its capital structure to 50 percent debt. (10 points)

$87000 x (1- 0.34) = $57,420

The weighted average cost of capital = 14.6%

($57,420/14.6) x 100 = $393,287.67

The value of the firm if capital structure changes to 50% debt: (.5x4.884)+(.5x14.6)

2.442+7.3 = 9.742%

Value of the firm = earnings after tax/wacc: = ($57420/9.742 ) x 100 = $589406.69

Suppose that you are the CFO of Harris Manufacturing. Draft a brief memo to the CEO outlining your views against increasing the firms debt ratio