When a firm raises funds through external debt or equity, it must incur issue costs (in contradiction to the Modigliani & Miller theorem). Introducing gearing or leverage increases (1) firm value due to tax benefits (M&M, 1963), (2) cost of equity as a result of shareholders exposure to financial distress risk (M&M, 1958) and (3) cost of debt due to bankruptcy risk or firms probability of failure.

Required:

(i) Explain the effect of issuance cost on firm value