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[solution] » (a) Chuma Company Ltd is considering various levels of debt.

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(a) Chuma Company Ltd is considering various levels of debt.
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(a)         Chuma Company Ltd is considering various levels of debt.  Currently it has no debt.  It has a total market value of Sh.30 million.  By undertaking debt it believes that it can achieve a net tax advantage equal to 20% of the amount of debt.  However the company will incur bankruptcy and agency costs as well as lenders increasing their interest rate if it borrows too much.  The company?s managing director believes that the company can borrow up to Sh.10 million without incurring any of these costs.  However, each additional Sh.10 million increment in borrowing is expected to result in the three costs cited being incurred.  Moreover, the three costs are expected to increase at an increasing rate with leverage.  The present value cost of various levels of debt is as follows:

           

Debt in millions of shillings

PV cost of bankruptcy, agency and increased interest rate

10

20

30

40

50

60

  0

  0.6

  2.4

  4.0

  6.4

10.0

Required:

a)         Advise the managing director on the optimal amount of debt for Chuma Company.          (10 marks)

 







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