Question $4$

Turf plc is an all$-$equity financed company with a cost of capital of $20\%.$ The

company$$s operating cash flows before interest and tax amount to Rs$12$ M$.$

These have been constant in recent years and are expected to remain so for

the foreseeable future.

The company proposes to change its capital structure by repurchasing Rs$10$ million

of the worth of equity and replace it with a fresh issue of $10\%$ undated debentures.

Free cash flows are distributed in full to providers of capital.

Corporate tax is at the rate of $25\%.$

Required:

Using the assumptions of Modigliani and Miller $($with corporate taxes$),$ calculate:

$($i$)$ The revised valuation of Turf plc after the capital change, clearly showing the

breakdown between equity and debt. Explain how the new value of equity has

been reached.

$(9$ marks$)$

$($ii$)$In line with Modigliani$-$Miller$$s theory of capital structure, Firms should increase

debt finance in their capital structure to increase the value of the interest tax

shield and increase the total value of the firm.$$

Identify and explain FOUR factors which might prevent a company from

gearing up to avail of the value of the interest tax shield.

$(16$ marks$)$