Question 5) A

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Question 5)

A. Discuss the static trade-off theory and the pecking order theory of capital structure. What are the main differences between these two theories? (10 points)

B. Global Production (GP) is a large conglomerate thinking of entering the smart alarm business, where it plans to finance a project with a debt-to-value ratio of 20 percent. GP expects to borrow for its smart alarm venture at an interest rate of 10%. There is currently one firm in the smart alarm industry, American Smart Alarm (ASA). This ASA firm is financed with 25 percent debt and 75 percent equity. The beta of ASA’s equity is 1+(0.1x1 ) (. ASA has a borrowing interest rate of 9%. The corporate tax rate for both firms is 26%+(1%xA) (with A defined above). The market risk premium is 8%, and the risk-free rate is 5%. What is the appropriate discount rate (RWACC) for GP to use for its smart alarm venture?