Reference no: EM132604945

a) Corporate leaders usually find themselves at a cross-road regarding the decision on whether to engage in leverage to boost the firm value as this is a "double-edge sword" situation. More debt in the capital structure can raise the value of a firm and that same debt can reduce the value of a firm.

Explain the validity or otherwise of the above assertion and if possible anchor your discussion on the "Trade-off Theory" as postulated by Modigliani and Miller-1963.

In the course of your discussion, offer guidance on the existence or otherwise of an optimal capital structure as a way of alleviating the decision jargon that corporate leaders have to deal with

b) BXT Inc. is considering a new investment project and evaluates the opportunity to increase its debt-to-equity ratio. The company has currently 20 million shares outstanding at a market price of ksh25. The total market value of the debt is ksh200 million and the rating of the company is BBB. The beta of the equity capital is 1.5. BXT is subject to a corporate tax rate of 35%.

You evaluate that the rating of the company would be downgraded to B, if it borrows ksh100 million. The interest rate is 11% for the debt of a BBB-rated firm and 12.5% for the debt of a B-rated firm. The risk-free rate is 8% and the market risk premium is 5.5%

Required:

a) Calculate BXT's WACC

b) What is BXT's cost of capital (K0) if it were all-equity financed?

c) Compute the new debt-to-equity ratio considered by BXT and the new WACC.

d) Should BXT ltd borrow the ksh100 million? Explain your answer