Question 5 (11 marks)

a) How do taxes affect the choice of debt versus equity? (2 marks)

b) Bradd Enterprises is currently an all-equity financed firm with an expected return of 12%. It is considering borrowing money to buy back some of its existing shares, thus increasing its leverage. Assume a perfect capital market.

i) Suppose Bradd borrows to the point that its debt-equity ratio is 0.75. With this amount of debt, the cost of debt is 7%. What will the expected return of equity be after this transaction? (1 mark)

ii) Suppose that instead, Bradd borrows to the point that is debt-equity ratio is 1.3. With this amount of debt, Bradds debt will be much risker. As a result, the cost of debt will be 8%. What will the expected return of equity be in this case? (1 mark)

iii) Discuss your answers in i) and ii) with reference to Modigliani and Millers Proposition 2 (MM2). (1mark)

c) Milton Industries expects free cash flows of $5 million each year. Miltons corporate tax rate is 30%, and its unlevered cost of capital is 10%. The firm also has outstanding debt of $20 million, and it expects to maintain this level of debt permanently.

i) What is the value of Milton Industries without leverage? (1 mark)

ii) What is the value of Milton Industries with leverage? (2 marks)

iii) Based on your answers in i) and ii), discuss the impact of capital structure on firm value under Modigliani and Millers proposition 1 (MM1) with taxes. (1 mark)

d) How can the use of debt financing better align the incentives of managers with the interests of shareholders? (2 marks)