Advanced financial management revision question and answer

Advanced Financial Management Block Revision Mock Exams

a) Two firms, A Ltd and B Ltd. operate in the same industry. The two firms are similar in all aspects except for their capital structures.

The following additional information is available:

1. A Ltd is financed using Sh.100 million worth of ordinary shares.
2. B Ltd is financed using Sh.50 million in ordinary shares and Sh.50 million in 7% debentures
3. The annual earnings before interest and tax are Sh.10million for both firms. These earnings are expected to remain constant indefinitely.
4. The cost of equity in A Ltd is 10%
5. The corporate tax rate is 30%

Required:

Using the Modigliani and Miller (MM) model, determine the following:

i) The market value of A Ltd. and B Ltd.
ii) The weighted average cost of capital of A Ltd and B Ltd.

b) Proton Ltd. has a capital structure consisting of Sh.250 million in 12% debentures and Sh.150 million in ordinary shares of Shs.10 par value. The company distributes all its net earnings as dividends.

The finance manager of Proton Ltd. intends to raise an additional Sh.50million to finance an expansion programme and is considering three financing options.

Option one: Issue an 11% debenture stock
Option two: Issue 13% cumulative preference shares
Option three: Issue additional ordinary shares of Sh.10 par value. The coporation tax rate is 30%.
Required:

Calculate the earnings before interest and tax (EBIT ) and the earnings per sharee (EPS)at the point of indifference between the following financing options:

i) Option one and option three
ii) Option two and option three
ANSWER

a) i) Computation of values and WACC

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