(a) Berlan plc has annual earnings before interest and tax of £15 million. These earnings are expected to remain constant. The market price of the company's ordinary shares is 86 pence per share cum div and of debentures £105.50 per debenture ex-interest. An interim dividend of six pence per share has been declared. Corporate tax is at the rate of 35 per cent and all available earnings are distributed as dividends. Berlan's long-term capital structure is shown below:
£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.