Light Speed plc requires 2,000,000 to fund a new project. The firm expects to earn an EBIT of 250,000 p.a. in perpetuity. Assume the project does not affect the operating risk of the company. The company intends to finance the project by issuing 1 million of 5% debentures at par and 1 millions worth of ordinary shares. The current capital structure of the company is as follows:

MV('000) Required return (%)

Debt (riskless) 4,000 5

Equity 16,000 15

The corporation tax rate is 25%. There is no time lag between taxable flows and the tax payments or receipts arising from those flows. Assume the required return on the market portfolio is 15% and the risk-free rate is 5%. Ignore income tax.

Required:

Evaluate how the change of capital structure affects the company value and dividends. You should clearly specify your choice of gearing model and comment on how different models/assumptions made would/would not affect the results. Please include references if needed.