) The probability of financial distress should be negligible for companies with a low proportion of debt. Therefore, a low proportion of debt should not have any noticeable effect on the cost of equity.

Question 2

In April 1997, Telstra, then a telecommunications company wholly owned by the Australian Government, announced a capital restructuring ahead of its proposed partial privatisation through a share market float during the second half of 1997. The capital restructuring involved payment of a special dividend of $3 billion to the government and the borrowing of $3 billion by Telstra. Its finance director reportedly said that 'the restructuring would lower the average cost of capital and enable greater financial flexibility'. Similarly, one journalist noted that 'debt financing is cheaper than equity raising'. His article also stated that 'debt interest payments are also tax deductible, while dividends are not'. Critically evaluate these comments on the effects of, and reasons for, the restructuring.

Question 3

Dorset Ltd is all-equity financed and has a cost of capital of 16 per cent per annum. An observer suggests that Dorset could easily borrow up to 40 per cent of the value of its assets at an interest rate of 10 per cent per annum and achieve a rating for its debt of A+ or better. He argues that raising new capital by borrowing would lower the company's cost of capital, and increase the net present value of some projects that were recently rejected. Use a numerical example to illustrate the observer's argument. Is his argument correct? Give reasons for your answer.