When a firm raises funds through external debt or equity, it must incur issue costs (incontradiction to the Modigliani & Miller theorem). Introducing gearing or leverage increases (1)firm value due to tax benefits (M&M, 1963), (2) cost of equity as a result of shareholdersexposure to financial distress risk (M&M, 1958) and (3) cost of debt due to bankruptcy risk orfirm’s probability of failure.Required:(i) Explain the effect of issuance cost on firm value.(ii) Evaluate the effect of gearing on cost of capital and firm value taking intoconsideration the three issues above.(iii) Discuss when and how to use the WACC as a discount rate for valuation.

Which of these is a main characteristic of debt capital?(a) Investors in debt participate in the ownership of the firm.(b) Investors in debt are paid interest.(c) Debt is more risky for the investor and less risky for the firm.(d) If dividends are not paid, this can lead to foreclosure, legal proceeding and financial distress.

A common problem facing any business entity is the debt versus equity decision. When funds are required toobtain assets, should debt or equity financing be used? This decision also is faced when a company is initiallyformed. What will be the mix of debt versus equity in the initial capital structure? The characteristics of debt arevery different from those of equity as are the financial implications of using one method of financing as opposedto the other.Cherokee Plastics Corporation is formed by a group of investors to manufacture household plastic products.Their initial capitalization goal is $50,000,000. That is, the incorporators have decided to raise $50,000,000 toacquire the initial assets of the company. They have narrowed down the financing mix alternatives to two:1. All equity financing2. $20,000,000 in debt financing and $30,000,000 in equity financingNo matter which financing alternative is chosen, the corporation expects to be able to generate a 10% annualreturn, before…

The company cost of capital depends on current profits and cashflows, which measures what investors require from the company: A) True B) False Corporate debt can be dependable or risky, which depends on the value and the risk of the firm's assets. Bondholders can take steps to eliminate default risk: A) true B) False