Phil’s is a sit-down restaurant that specializes in home-cooked meals. Theresa’s is a walk-in deli that specializes in speciality soups and sandwiches. Both firms are currently considering expanding...

Phil’s is a sit-down restaurant that specializes in home-cooked meals. Theresa’s is a walk-in deli that specializes in speciality soups and sandwiches. Both firms are currently considering expanding their operations during the summer months by offering pre-wrapped doughnuts, sandwiches, and wraps at a local beach. Phil’s currently has a WACC of 14% while Theresa’s WACC is 10%.

The expansion project has a projected net present value of £12,600 at a 10% discount rate and a net present value of -£2,080 at a 14% discount rate.

Theresa’s belongs to Harvester, which has expected earnings before interest and tax
(EBIT) of £45,000 in perpetuity and a tax rate of 30%. Harvester has £60,000 in outstanding
debt at an interest rate of 8%. The unlevered cost of capital is 12.

1. What is the value of Harvester according to Modigliani and Miller Proposition I with taxes?

2. Should Harvester change its debt-equity ratio if the goal is to maximize the value of the
firm? Why?