a. Explain how the level of risk to equity holders is a function of the firm's operating leverage (its fixed and variable costs) and the financial leverage (level of debt) in the balance sheet.

(3 marks)

b. In the Miller and Modigliani (M&M) theory of capital structure they distinguish between the impact of changing the debt used on the Weighted Average Cost of Capital (the WACC) of the company (Proposition 1) and the cost of equity (Proposition 2). In a world of perfect markets they argue that the WACC is unaffected by the level of debt in a company's balance sheet, but the cost of equity is. Explain how this can happen.

a. Explain how the level of risk to equity holders is a function of the firm's operating leverage (its fixed and variable costs) and the financial leverage (level of debt) in the balance sheet.

(3 marks)

b. In the Miller and Modigliani (M&M) theory of capital structure they distinguish between the impact of changing the debt used on the Weighted Average Cost of Capital (the WACC) of the company (Proposition 1) and the cost of equity (Proposition 2). In a world of perfect markets they argue that the WACC is unaffected by the level of debt in a company's balance sheet, but the cost of equity is. Explain how this can happen.

(5 marks)

c. In the M&M approach with taxes the cost of equity is related to the level of debt in the balance sheet as follows: Re = Ru + (Ru - Rd) x D/E x (1-Tc) where Re = cost of equity; Ru = unlevered firm's risk adjust rate of return;Rd = cost of debt; D = amount of debt used by the firm, E = amount of equity used by the firm; and Tc = tax rate.

You have the following information about a company:

EBIT = R150m

Tax rate = 28%

D = R200m

Rd = 15%

Ru = 20%

You can assume that the company is paying out all earnings as dividends (i.e. there is no growth).

Use this equation in conjunction with the information above to answer the following questions about the company.

1. What is the value of the company if it does not use any debt (i.e. its unlevered value)?

(2 marks)

2. What is the value of the company given the use of debt as outlined above?

(2 marks)

3. What is the Return on Equity (Re) for the firm with debt? NB: you need to work out the D/E ratio first.

(3 marks)