Advanced financial management revision question and answer

KK Ltd. and KT Ltd. are two companies in the printing industry. The companies have the same business risk and are almost identical in all respects for their capital structures and total market values. The companies capital structures are summarised below:
KT‟s ordinary shares are trading at Sh.170 and debentures at Sh.100. Annual earnings before interest and tax for each company is Sh.50 million.
Corporate tax is at the rate of 30%.
Required:
a) If you owned 4% of the ordinary shares of KT Ltd. and you agreed with the arguments of Modigliani and Miller, explain what action you would take to improve your financial position.

b) Estimate how much your financial position is expected to improve. Personal taxes may be ignored and assumptions made Modigliani and Miller may be used.

c) If KK Ltd. was to borrow Sh.40 million, compute and explain the effect this would have on the company‟s cost of capital according to Modigliani and Miller. What implications would this suggest for the company‟s choice of capital structure?

ANSWER


(b) On the basis of δ/P.V (amount of risk per unit of P.V)
Project A is clearly dominated both E and C. Project B A, C and E. Project C none. Project D all other projects. Projects E C. Size problem should not be ignored.
NB:The lower the δ/P.V, the better the project.


Note: Use normal distribution tables to find the probability.

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