Red World generates EBIT of £200 million. It currently does not have debt in the capital structure, but it is considering the use of debt and exploring raising either £700 million or £1,500 million. Interest on debt is payable at the rate of 6%. Ignoring taxation and bankruptcy costs and assuming all earnings after interest are paid to shareholders as dividends, which is the most attractive capital structure for Red World? Explain (maximum 250 words).

Debt is beneficial in capital structure because it is tax saving. When we pay interest, our earnings before tax is reduced and hence tax is reduced. But here, we have to ignore effects of taxation and bankruptcy costs and all the earnings after paying interest would go to equity shareholders as dividends and we also do not know the equity structure of the firm. So the less the debt, the more beneficial it is for the equity shareholders of the company. Here, dividend per share would increase if we pay less interest. And the aim of business is always to main low cost of capital and maximise profits and return on equity.

Therefore, the company can raise a debt 700 pound million.

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