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Your company Chief Finance Officer (CFO) recently read on the Business Daily about notion that adjusting the capital structure can increase market value of a
Your company Chief Finance Officer (CFO) recently read on the Business Daily about notion that adjusting the capital structure can increase market value of a firm dramatically. T CFO liked the idea and has asked you to do a preliminary study on the issue. The CFO wi entertain any proposal to increase the debt of the company up to a maximum debt-equity ratio 30 per cent. Currently, your company is very conservative with its leverage and has a Debt-equity ratio o only ten percent. You estimate the beta of your stock to be 1.2 based on the last five years' data The marginal tax rate is 30 per cent. The long term Treasury bond rate is 7 per cent and marke risk premium is 5 per cent. You have obtained the approximate relationship between the pre-tax cost of debt and the debtequity ratio from an investment banker, as follows: In addition, from the statement of changes in cash flow, you extracted the following data: (i) EBIT= sh. 120 million (ii) Depreciation = Sh.10.5 million (iii) Capital spending = sh. 15 million (iv) Net working capital spending =0 The growth rate in future cash flows is estimated to be constant at 5 per cent per annum. Recuired: (i) Compute the market value of your company when the debt-equity ratio is ten percent. [10 marks] (ii) Advise the company on the optimal debt-equity Ratio based on the data provided. [15 marks]
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