Question:
(a) According to Modigliani and Miller's Theory of Capital Structure (1963), companies should make maximum use of gearing.
Briefly, describe factors which might prevent a company from making maximum use of debt finance in its capital structure.
(b) Sale-Sucre plc specialises in the production and sale of pizzas. It is considering increasing production and plans to invest in a new kitchen oven costing Rs2,400,000 payable immediately. The company can acquire the equipment in two ways:
I. Outright purchase via a 4-year bank loan at a pre-tax interest cost of 9%. The terms of the loan agreement would entail an upfront transaction cost of 2% of amount raised and the loan would be repayable by equal annual instalments starting one year from now.
II. A financial lease with annual rentals of Rs675,000 over 4 years payable in advance.
Tax is levied at the rate of 15% and is payable in the year in which profit occurs. Depreciation is a tax-allowable expense and is granted only to the legal owner o f the asset. Rentals payable by the lessee under the lease arrangement are fully tax-deductible.
Required:
Determine which financing option the company should go for.