JAG is a British car manufacturing company. JAG expects to generate an annual EBIT of 2.5

million in 1 year and this figure is not expected to change. JAG makes fixed capital investments

of 700,000 every year, its depreciation expense is constant at 150,000 per year, and its

working capital balances are expected to stay constant at 200,000. The firm currently has

no debt and 400,000 shares outstanding. JAGs equity beta is 1.3, the risk free rate is 1%, and

the market risk premium is 5%. The corporate tax rate is 35%.

(a) What are JAGs current share price, earnings per share (eps) and cost of equity?

(b) JAG decides to borrow 5 million by issuing a 8-year bond paying annual coupons at 4%,

which is also equal to the cost of debt, so that 5 million is also the nominal amount

of the bond. JAG then uses the proceeds of the bond issue to repurchase shares at a

price that renders shareholders indifferent between selling and not selling. What are

JAGs share price, earnings per share and cost of equity after the bond issue and share

buyback?

(c) Briefly describe the tradeoff theory of capital structure. Based on this theory, what

what effect would an increase in the corporate tax rate have on the optimal capital structure

of firms in the economy?

of firms in the economy? [3 marks]

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