Question 3 Financial Leverage and Capital Structure Theory (30 marks)

3.1 Currently, Minelli Enterprises Limited does not use financial leverage, and its total capital is $120 million with a share price of $1.20 each. The company is considering refinancing by issuing $24 million of debt, which pays an annual coupon rate of 6.25% and using that money to buy back 20% of the companys ordinary shares. Minelli Enterprises Ltds earnings before interest and tax (EBIT) are expected to be constant for the foreseeable future, and all profits are paid out as dividends. Currently, the weighted average cost of capital is 9.25%.

Required:

(a) Using the assumptions of Modigliani and Miller, if the company goes ahead with the refinancing option, calculate the cost of equity capital. (4 marks) (Assumption: the company operates in a no-tax environment).

(b) Using the assumptions of Modigliani and Miller, if the company goes ahead with the proposal, calculate the following: (Assumption: The company tax rate is 28%) i. The value of the company ii. The debt to equity ratio of the company iii. The new cost of equity capital iv. The revised weighted average cost of capital. (12 marks)

(c) If you were the financial manager of Minelli Enterprises Ltd, will you use more and more leverage to increase the firm value indefinitely and lower its cost of capital continuously? Explain why or why not. (8 marks)

3.2 Tea-Tree Bay Limited is considering two financing plans to raise $10 million. The company tax rate is 28%.

Plan A: This plan is an all-ordinary share plan, where the company sells 1,000,000 shares at $10 per share.

Plan B: This plan uses financial leverage. The company is considering a debt (Bonds) Issue with a 20-year maturity period. The bond issue will carry a coupon rate of 5.5% per annum, and the principal borrowed will amount to $5 million, and the remaining $ 5 million would be raised by selling ordinary shares at $10 per share. The financial leverage option is considered to be a permanent part of the companys capitalisation, and hence no fixed maturity date is needed for the analysis. Required: Find the EBIT indifference level associated with the two financing plans Note: All workings must be provided (6 marks)