Question

Assume you have just been hired as a Finance Manager of Anjung Puteri. The company’s earnings before interest and taxes (EBIT) was RM500,000 last year and is expected to remain constant over time. Since no expansion capital will be required, Anjung Puteri plans to pay out all earnings as dividends. The management group owns fifty percent (50%) of the stock and the rest is traded in the over-the-counter market.

In your finance course, you learned that most firm owners would be financially better off if the firm used some debt. When you suggested this to your new boss, she encouraged you to pursue the idea. Anjung Puteri is currently financed with all equity, it has 100,000 shares outstanding and the current market price is RM15 per share. If Anjung Puteri were to recapitalize, debt would be used, and the funds received would be used to repurchase stock at the RM15 per share market price. Anjung Puteri is in a 24% tax bracket. The company leases all its equipment and its building. Therefore, Anjung Puteri has no depreciation expense.

From your finance training, you know that there is an optimum relationship between debt and equity at which the market value per share will be maximized. You recall that you can use estimated cash flows, weighted average cost of capital (WACC), and the capital asset pricing model (CAPM) to estimate share value. As a first step you found the following information on Yahoo finance:

“The current prime borrowing rate is 5.14% and the current risk-free rate (10 year Malaysia Government bond) is 3.07%. You estimate the market risk premium into the foreseeable future at 8%.

Next, you obtained from a local investment banker the following estimated debt risk premiums and subjective betas for Anjung Puteri at various debt levels:

Scenario	Amount Borrowed (RM)	Debt Risk Premium (%)	Subjective Beta
1	0	2.0	2.0
2	187,500	2.0	2.1
3	375,000	2.5	2.3
4	562,500	3.5	2.5
5	750,000	5.0	2.9
6	937,500	7.0	3.3
7	1,125,000	10.0	3.7

Required:

1. Briefly explain the trade-offs between debt and equity financing.

Answer 1