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Starc Enterprises is a listed company and its ordinary shares are trading at R25 per share (500 000 shares in issue)

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Starc Enterprises is a listed company and its ordinary shares are trading at R25 per share (500 000 shares in issue). The company also has 20 000 bonds (par value of R1 000) in issue, which is currently trading at R750. The bonds mature in 20 years and pay a 10% coupon. As an advisor to the company you have been informed that the before tax cost of debt is 9.5% and you also know that a 25% tax rate applies to the company. With respect to the ordinary shares, the following information applies: • Risk-free rate = 5% • Market risk premium = 11% • Beta coefficient = 1.4 You are also aware that the company’s board is considering a new project that requires an initial investment of R250 000 for new equipment, which is expected to generate a net cash flow of R35 000, R60 000, R80 000 and R100 000 at the end of the first, second, third and fourth year respectively. The equipment has a salvage value of R50 000 at the end of the fourth year and a discount rate of 12% applies. Although the company is considering new projects, senior management has recently expressed concern about its working capital management. The following information has been supplied to you in this respect: • Inventory turnover = 15 times • Debtors turnover = 12 times • Average payment period = 25 days

During your discussions with senior management, one of the managers mentioned the following about the company’s capital structure: “The cost of debt is typically lower than the cost of equity and we should therefore use more debt financing than equity.” In light of the statement above, argue either in favour or against the view expressed by the manager