You are a new recruit in the finance division of LargeCompany Plc. Your finance director has asked you to review the companys capital structure when the amount of debt is changed. She has provided you following information from last year annual report in 000 Short Term Debt/Current Portion of Long Term Debt 1,700,000 Long Term Debt 9,700,000 Total Equity 18,000,000 Shares Outstanding 1,700,000 Further, you collected following market information from the New Financial Times. Stock Price (per share) 27 Current Yield to Maturity on outstanding Bond 0.90% Cost of unlevered equity is 10 %

. You would like to show your understanding of capital structure that you learnt in your corporate finance course In particular, you want to demonstrate

A) in a perfect capital market, a firms choice of capital structure is unimportant. (30 Marks)

B) in real world market imperfections like taxes can not be ignored. As interest payments create a valuable tax shield, the stock price should increase if firm decides to increase its debt i.e. higher leverage higher firms value (30 Marks)

C) your knowledge of existing literature on capital structure theories (20 Marks)

Please follow the guidelines below while answering

For A: you are suggested to

1. Compute the market Debt to Equity ratio.

2. Compute the cost of levered equity based on market Debt to Equity ratio

. 3. Compute the current weighted average cost of capital (WACC).

4. Repeat steps 2 and 3 for Scenario i) issue 1 billion in debt to repurchase stock, and Scenario ii) issue 1 billion in stock to repurchase debt.

Briefly comment the results.

Note: i. approximate the market value of debt by the book value of debt

ii. debt includes Long-Term Debt and Short-Term Debt/Current Portion of Long-Term Debt.

iii. existing yield on the outstanding bond can be used as cost of debt

iv. assume cost of debt capital remains constant

For B: you are suggested to Examine the impact of

a) issuing 1 billion in new debt (adding a modest level of debt) and

b) issuing 5 billion in new debt (i.e. adding a higher level of debt).

In both the cases, you plan to use the proceeds to repurchase stock.

Note: i. assume a tax rate of 40%

ii. begin by analysing the scenario with 1 billion in new debt. Assuming the company plans to keep this new debt outstanding forever, determine the present value of the tax shield of the new debt.

iii. find out new market value of equity. new market value of equity = existing market value + tax shield amount

iv. find out new market value of equity after repurchase

v. find out the new share price vi. new number of shares outstanding = no of shares outstanding (given) less number of shares repurchased

vii. now find out Debt to Equity ratio based on a) book values and b) market values

viii. repeat ii vii for 5 billion new debt issuance

For C: you are suggested to Read and review journal articles related to Trade off, Asymmetric of the information hypothesis, Pecking order theory, Signaling theory, Agency cost theory, and Market timing theory.