(a) Berlan plc has annual earnings before interest and tax of 15 million. These earnings are expected...
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£000
Ordinary shares (25 pence par value)..........................12,500
Reserves...........................................................24,300
......................................................................36,800
16% debenture 31 December 2017 (£100 par value).......23,697
.......................................................................60,497
Required
Calculate the cost of capital of Berlan plc according to the traditional theory of capital structure. Assume that it is now 31 December 2014.
(b) Canalot plc is an all-equity company with an equilibrium market value of £32.5 million and a cost of capital of 18 per cent per year. The company proposes to repurchase £5 million of equity and to replace it with 13 per cent irredeemable loan stock.
Canalot's earnings before interest and tax are expected to be constant for the foreseeable future. Corporate tax is at the rate of 35 per cent. All profits are paid out as dividends.
Required
Using the assumptions of Modigliani and Miller, explain and demonstrate how this change in capital structure will affect Canalot's:
(i) Market value
(ii) Cost of equity
(iii) Cost of capital
(c) Explain any weaknesses of both the traditional and Modigliani and Miller theories and discuss how useful they might be in the determination of the appropriate capital structure for a company.
Debentures
Debenture DefinitionDebentures are corporate loan instruments secured against the promise by the issuer to pay interest and principal. The holder of the debenture is promised to be paid a periodic interest and principal at the term. Companies who... Capital Structure
Capital structure refers to a company’s outstanding debt and equity. The capital structure is the particular combination of debt and equity used by a finance its overall operations and growth. Capital structure maximizes the market value of a... Cost Of Capital
Cost of capital refers to the opportunity cost of making a specific investment . Cost of capital (COC) is the rate of return that a firm must earn on its project investments to maintain its market value and attract funds. COC is the required rate of... Cost Of Equity
The cost of equity is the return a company requires to decide if an investment meets capital return requirements. Firms often use it as a capital budgeting threshold for the required rate of return. A firm's cost of equity represents the... Dividend
A dividend is a distribution of a portion of company’s earnings, decided and managed by the company’s board of directors, and paid to the shareholders. Dividends are given on the shares. It is a token reward paid to the shareholders for their...
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Related Book For
Corporate Finance and Investment decisions and strategies
ISBN: 978-1292064062
8th edition
Authors: Richard Pike, Bill Neale, Philip Linsley
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