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Company ABC expects next year's operating earnings (EBIT) to be $2 million. Suppose it has total assets of $10 million and no debt. It currently has 1 million shares outstanding with a book value of $10 per share. It is planning a capital restructuring to achieve a debt-to-book equity ratio of 1. Based on yields on similar debt in the marketplace, the company estimates that it will have to pay 6% interest rate if it issues bonds. The income tax rate applicable to the company is 25%.
1) Applying Modigliani and Miller capital structure theory to this example, appraise whether the firm is doing the "right thing" by moving from an all-equity asset base to a debt equity ratio of 1.
2) Two years have passed and the world economy is slowly recovering after surviving through the pandemic for 2 years. World economies have been dipping into their reserves to finance the hardships caused by the pandemic. Company ABC, being in the biomedical field, has been doing well and now needs additional funds for expansion. It is considering whether to launch a rights issue or to issue a convertible bond. You have been engaged as a financial advisor for the company. Compare the differences between a convertible bond and a rights issue from the viewpoint of the company.
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