Advanced financial management revision question and answer

The governments of many less developed countries have experienced problems in recent years as their debt levels have risen leading to what has been called a “global debt crisis”.

Required:
a) Explain briefly why these problems amount to a “crisis.
b) Discuss the approaches that have been used to overcome the problems.
c) Outline the benefits to multinational business enterprises of resolving the current global debt problems.
answer
a) Modigliani and Millers would argue that the total value of the companies is independent of the capital structure except to the extent of the tax advantage enjoyed debt. This is given the value of debt x tax rate.

The value of the two companies are:


Theoretically the value of KT Ltd. should exceed that of KK Ltd value of debt x tax rate. 500,000,000 x 30% = 15,000,000.

The value of KT Ltd exceeds that of KK Ltd 23,000,000. KT Ltd is therefore over valued as compared to KK Ltd. The investor in KK Ltd can improve his financial position arbitrage. This will be achieved by: Selling the holding in KK Ltd.
Borrowing initial personal gearing which is the same as the gearing in the capital structure of KT Limited and Then investing the proceeds in the shares of KK Limited.


The investor in KT Limited is currently receiving 4% of that firm‟s income i.e 4% x 30,800,000 =
1,232,000.
He should sell the shares in KT Limited realizing 85,000,000 x 0.04 = 3,400,000.
He should borrow Sh.1,400,000 (4% x 50M)(1-0.3) to duplicate the gearing of KT Limited and then invest the combined total of 4.8M(3.4M + 1.4M) in KK Ltd.

Which is 1260 – 1232 = 28 greater than before.

c) If KK Ltd borrows 40,000,000; Modigliani and Miller would indicate that its values will rise by:-
Value of debt x tax rate 40,000,000 x 30% = 12,000,000

Assuming that the debt replaces equity the value of KK Ltd: 112 + 12 = 124 million of which 40 million is debt. Therefore equity = 124M – 40M = 84M


MV of equity = 84M and cost of equity = 37.67%
MV of debt = 40M and cost of debt = 12%(1-0.3) = 8.4%

The weighted cost of capital is 28.23% which has dropped from 31.25%. Implications:
Gearing reduces WACC up to a point where threat of bankruptcy over weighs the tax shield advantages.

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