Question 5 (11 marks)

a) How do taxes affect the choice of debt versus equity? (2 marks)

b) Bradd Enterprises is currently an all-equity financed firm with an expected return of 12%. It is considering borrowing money to buy back some of its existing shares, thus increasing its leverage. Assume a perfect capital market.

i) Suppose Bradd borrows to the point that its debt-equity ratio is 0.75. With this amount of debt, the cost of debt is 7%. What will the expected return of equity be after this transaction? (1 mark)

ii) Suppose that instead, Bradd borrows to the point that is debt-equity ratio is 1.3. With this amount of debt, Bradds debt will be much risker. As a result, the cost of debt will be 8%. What will the expected return of equity be in this case? (1 mark)

iii) Discuss your answers in i) and ii) with reference to Modigliani and Millers Proposition 2 (MM2). (1mark)