Advanced financial management revision question and answer

(a) Karim Ltd has annual earnings before interest and taxes of Sh.150 million. These earnings are expected to remain constant. The market price of the company‟s ordinary shares is Sh.8.60 per share cum dividend and of debentures sh.1055.0 per debenture ex. Interest. An interim dividend of Sh.0.60 per share has been declared. Corporate tax is at the rate of 30% and all available earnings are distributed as dividends.
Karim‟s long term capital structure is shown below:

Required:
Calculate the cost of capital of Karim Ltd according to the traditional theory of capital structure. Assume it is now 31.12.X1 and the capital structure is optimal..

(b) Canalot Ltd is an all equity company with an equilibrium market value of Sh.32.5 million and a cost of capital of 18% per year. The company proposes to repurchase Sh.5 million of equity and to replace it with 13% irredeemable loan stock. Canalot Ltd‟s earnings before interest and taxes are expected to be constant for the foreseeable future. Corporate tax is at the rate of 30%. All profits are paid out as dividends.

Required:
Using the assumptions of Modigliani and Miller explain and demonstrate how this change in capital structure will affect:

(i) the market value the cost of capital
the cost of equity of Canalot Ltd.

ANSWER
(a) Since Karim has constant earnings all of which are distributed as dividends, the cost of equity can be

(b) Using Modigliani and Miller‟s theory:

(i) The market value will equal the market equity financed, plus the PV of tax relief on any debt interest.


The market value will increase sh.1.5M = (Sh.34M – 32.5M)

(ii) Using answer to (b) (III) below cost of capital

The weighted cost of capital has fallen 0.8% due to the benefit of tax relief on debt interest payments.

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