Simphiwe is the financial manager of S&S Ltd and has been instructed to find a suitable funding instrument for new equipment that needs to be purchased at a cost of R375 000. He has identified two possible funding instruments, namely a loan from CapC Bank and the issue of new shares. He has discussed the loan option with the bank manager from CapC Bank and also had discussions with a few investors that are interested in taking up some shares in S&S Ltd.

The following information is available based on the outcome of his discussions:

CapC Bank

1. The bank manager of CapC Bank has agreed to grant a loan of up to 100% of the total purchase value.

2. The loan will be granted in multiples of R75 000, and S&S Ltd can decide how many multiples they would like to borrow from the bank.

3. For a 100% loan, the risk is higher and therefore the interest rate charged for a 100% loan is 17.5% before tax.

4. For every R75 000 not taken up by S&S, the interest rate will decrease by 0.50% as the risk to the bank reduces.

Issue of new shares to prospective investors

1. Investors are very keen to invest in S&S Ltd and after discussions, Simphiwe identified enough interested parties to take up 100% of the investment amount needed.

2. If everything is financed through equity the equity holders will require a return of 15% per annum on their investment.

3. If a portion of the funds are generated through the loan the investors are of the opinion that it will increase their risk and they will therefore require a greater return on their investment. They have agreed that they will require an additional return of 0.25% for every R75 000 that is borrowed from CapC Bank.

Additional information

The tax rate of the company is 28%.

REQUIRED

Determine the optimal capital structure of S&S Ltd to finance the new equipment.