The CFO of Benedict Inc., a listed company, wants to assess the possible impact on the companys overall cost of capital (weighted average cost of capital WACC) due to the introduction of debt financing. Currently, the company is an all-equity firm.

Current capital structure

Ordinary shares ($0.20 par value per share) $800,000

Reserves $1,200,000 Total $2,000,000

The companys current price is $2.1 per share and up to $4 million of fixed rate debt can be raised at an interest rate of 10% per annum.

Benedicts current EBIT (earnings before interest and taxes) is $2.5 million. These earnings are expected to remain at a constant level for the foreseeable future. The companys tax rate is 33%.

Two financing options are being considered by the company and the debt issue will be used to repurchase ordinary shares of the company:

i $2 million debt issue or ii $4 million debt issue

Required:

a Applying Miller and Modiglianis model in a world with company tax, calculate the impact on Benedicts cost of capital (WACC) by stating any assumptions you make based on the debt issue of:

• i $2 million or
• ii $4 million

What can you derive from (i) and (ii)?

(17 marks)

b Comment on whether or not your calculation in part (a) is likely to be correct. (8 marks)