The projected cash flows for a

The projected cash flows for a company to be established are £lm per year for ever. The company will require £9m in capital to be viable and produce the £lm annual cash flows. The prospective directors suggest that they raise £2m by borrowing from a bank at a fixed rate of 6 per cent per year. The remaining £7m will come from an issue of shares. Shares with a similar systematic risk are currently offering an of 11 per cent. This cautious level of borrowing suits the directors because their livelihood depends on the survival of the firm. The tax rate is 30 per cent.

Required

a. Calculate the WACC and the value of the enterprise (debt + equity value)

b. If a higher level of financial gearing is targeted such that £5m of the capital comes from lenders and £4m comes from shareholders the required rates of return change. The debt holders now require 7 per cent per annum, whereas the equity holders expect a return of 16 per cent per year. Does this raise or lower the WACC and value of the firm?

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