Question 1Plan IPlan II

Roberts Inc. is trying to decide how best to finance a start-up company investment: Two plans were suggested by the finance committee:

: An all-equity capital structure. The project will be financed entirely by $2 million which would be raised by issuing common stock at $20 per common stock share.

: Introduced capital gearing. Bonds $1 million with an effective rate of 11% will be issued. The balance of $1 million will be raised by issuing common stock at $20 per common share. The corporate tax rate for Roberts Inc is 30%.

i) Calculate the indifference level of earnings before interest and tax (EBIT) associated with the two financing plans. (5 Marks)

ii) If EBIT is expected to be $300,000 annually, which plan will result in a higher EPS? Give a detailed analysis of the firm’s prospects. (5 Marks)

Question 1

Modigliani and Miller’s work (MM) (1958 & 1963) initiated the discussion on the relevance of capital structure on the weighted average cost of capital and the market value of companies.

Discuss, detailing how the development of MM’s work led to them finally concluding that there is an optimal capital structure theory. (15marks)

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