Kagel Inc has a total market value of USD 100 million, consisting of 1 million shares selling for USD 50 per share and USD 50 million of 10% perpetual bonds now selling at par. The companys EBIT is USD 13.24 million, and its tax rate is 15%. Kagel can change its capital structure by either increasing its debt to USD 70 million or decreasing it to USD 30 million. If it decides to increase its use of leverage, it must call its old bonds and issue new ones with a 12% coupon. If it decides to decrease its leverage, it will call in its old bonds and replace them with new 8% coupon bonds. The company will sell or repurchase stock at the new equilibrium price to complete the capital structure change.

The firm pays out all earnings as dividends; hence, its stock is a zero growth stock. If it increases leverage, ks will be 16%. If it decreases leverage, ks will be 13%. (ks being the cost of equity).

Q) Should the firm change its capital structure?

Assume T=15%. How would your analysis of the capital structure change be modified if, in the case of increasing debt to USD 70 Million, the firms presently outstanding debt could not be called, and it did not have to be replaced; that is, if the USD 50 million of 10% debt continued even if the company issued new 12% bonds? Conclude.