QUESTION:

Your company Chief Finance Officer (CFO)recently read on the Business Daily about the notion that adjusting the capital structure can increase market value of a firm dramatically.The CFO liked the idea and has asked you to do a preliminary study on the issue.The CFO will entertain any proposal to increase the debt of the company upto a maximum debt-equity ratio of 30%..Currently, your company is very conservative with leverage and has a debt -equity ratio of only 10%.You estimate the beta of your stock to be 1.2 on the last five years data.The marginal tax is 30%.The long term Treasury bond rate is 7% and market premium is 5% ..

You have obtained the approximate relationship between the pre-tax cost of debt and the debt-equity ratio from an investment banker , as follows:-

Debt-Equity Ratio(%) Pre-Tax Cost of Debt (%)

10 10

20 11

30 12

In addition , from the statement of changes in cash flow, you extracted the following data:

1) EBIT=Sh.120 million

2)Depreciation =Sh.10.5 million

3)Capital Spending= Sh.15 million

4)Net working capital spending=0

The growth rate in future cashflows is estimated to be constant at 5% per annum,

Required:

i) Compute the market value of your company when debt-equity ratio is 10% (10 Marks)

ii) Advise the company on the optimal debt-equity Ratio based on the data provided (15 Marks