Shopwell Ltd is considering closing some of its stores across the country and investing in a few centrally located onlin

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Shopwell Ltd is considering closing some of its stores across
the country and investing in a few centrally located online
shopping hubs. The online shopping hubs and accompanying delivery
system are expected to reduce occupancy costs while at the same
time increasing sale but will cost a combined R500 million to
construct and implement. Shopwell Ltd will fund the new direction
for the company using a combination of debt and equity. The
company’s target capital structure is represented by a
debt-to-equity ratio of 81.82%. The following information is
available on the proposed debt and equity issuance: • Debt.
Shopwell Ltd will issue 10.80% coupon bonds with a par value of R1
000 each. The bonds will mature in 10 years. Coupons on the bonds
will be paid semi-annually in arrears. The yield to maturity on
similar bonds is currently 11.20%. • Equity. Shopwell Ltd’s
authorised share capital is 130 million shares. The company has 59
million shares in issue. The company recently paid an ordinary
dividend of R1.53 per share. Should the company successfully close
some of the existing stores and invest in the online shopping hubs,
earnings and dividends will be expected to grow at a rate of 15% in
the first year. The growth in earnings and dividends will gradually
decline by 3% per year until it reaches a sustainable rate of 6%
per annum. The required rate of return on Shopwell Ltd shares is
currently 15%.
Required: In a meeting of the board of directors, one of the
directors argue that the company should increase the percentage of
debt in its capital structure to increase the value of the firm.
Using relevant theories of capital structure, discuss whether the
director was correct.