Capital structure calculation

36236Suppose that Firm Z has a debt ratio slightly below average for its industry and has announced that it intends to conduct a significant new debt issue. Assume you are an investment advisor whose clients have sizeable proportions of their assets in Firm Z. What investment advice you would give, assuming you were a believer in 1) static trade-off theory, 2) agency theory, 3) signaling theory, and 4) pecking-order theory?

Firm Z has expected earnings before interest and taxes (EBIT) of £1,000,000 in perpetuity and a corporate tax rate of 37%. The debt that Firm Z currently has outstanding has an interest rate of 10% and totals £200,000. If the firm has an unlevered cost of capital rate of 13%, what is the value of Firm Z under MM Proposition I with taxes? If the financial managers of the firm seek to maximise firm value, do you believe that they should consider altering its debt–equity ratio? What effect will this have on the weighted cost of capital for Firm Z? How does your answer change if financial distress costs are also considered?

Be sure to include your analysis and all calculations in a MS Word document (“.doc” or “.docx”).

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