QUESTION THREE The CEO of Obelix Ltd, a utility firm specializing in supplying green energy to households, is interested

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QUESTION THREE The CEO of Obelix Ltd, a utility firm
specializing in supplying green energy to households, is interested
in the impact of adjusting the firm's borrowing policy to improve
its financial strength in light of the competition in the energy
sector. The CEO asks you to provide a report that you will present
to the board to offer workable financial policies for the firm. The
following table details the firm's current balance sheet. Note that
there is no information about the cost of equity capital. Value
Cost of capital Total assets £120m 10% Debt £40m 4% Equity £80m ?
The CEO realizes that by increasing the firm's debt burden, the
cost of debt capital will rise as there is an increase in the
bankruptcy risk of the firm. The following table estimates the link
between the debt-equity ratio and the cost of debt capital.
Debt-Equity ratio Cost of debt 1/2 4.00% 5/7 4.02% 6/6 4.05% 7/5
4.10% 8/4 4.50% The market data are as follows: The risk-free rate
3% The average return on the market index 7% Your report should
address the following points. a) What is the current cost of equity
capital? (5 marks) b) Work out the cost of equity for a debt-equity
ratio of one, as well as a debt-equity ratio of two. State the
assumptions you make. (10 marks) c) Explain what assumptions
underpin the trade-off theory of borrowing. Under what conditions
should the firm increase its borrowing according to this theory (15
marks) d) The board is interested in learning about the various
options for using borrowing. Outline the difference between, and
the relative benefits of, loans and bonds, fixed-rate and
variablerate debt, and domestic-issued bonds and Eurobonds. (