Question B2. (25 points)

The directors of Gamma plc are investigating the possibility of launching a new product line which will require an initial investment of 2,400,000.

The following is an extract from the Statement of Financial Position of Gamma plc for the year ended 31 December 2012:

Creditors due in more than one year
6% Debentures	1,600,000 D
Long-term loan	400,000
Capital and reserves
Issued share capital (4 million shares of 25p each)	1,000,000

The following information is also available:

• The authorized share capital is 8 million shares;
• The current market price per share at 31 December 2012 was 162p ex-dividend;
• The last dividend payment was 17 pence per share;
• Dividends are expected to grow at a constant rate of 7% per year;
• The current market price of debentures is 95 (ex-interest) and interest is payable each year on 31 December. The debentures are irredeemable;
• The interest rate on the long-term loan is 0.5 percentage points above LIBOR, which at present stands at 4 per cent.

Required

1. Calculate the weighted average cost of capital of Gamma plc.

(10 Marks)

2. Explain Modigliani and Millers argument that in a world of no taxes and no bankruptcy the value of the firm does not depend on its capital structure.

(5 Marks)

3. Explain how a firm's optimal capital structure is determined according to the static theory of capital structure (i.e. the traditional approach).

(5 Marks)