Topic: Capital Structure

Part B:(4 Marks)

King corporation is an unlevered firm with a market worth of $20 million. Given the tax benefit of debt, the company is considering changing its existing capital structure by adding debt. For this purpose, it plans to issue a permanent debt of $ 2 million and use the proceeds to buy back the shares. The debt would be issued at an interest rate of 7 percent.The corporate tax rate is 40%.

Required:

a.What is the effect of the new capital structure on the value of the firm? (2 Marks)

b.What is the effect of the new capital structure on the remaining value of equity?(2 Marks)