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Question - Canalot plc is an all equity company with an equilibrium market value of £32.5m and a cost of capital of 18%.
The company proposes to repurchase £5m of equity and replace it with 13% irredeemable loan stock.
Canalot's earnings before interest and tax are expected to be constant for the foreseeable future. Corporate tax is 35%. 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: (i) the market value; (ii) the cost of equity; and (iii) the cost of capital of Canalot plc.
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