Financial Management

Financial Management question

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 except for their capital structures and total market values. The company’s capital structures are summarized below:

KK Ltd $‘000’

Ordinary shares ($ 50 par value) 40,000

Share premium account 90,000

Profit and loss account 73,000

Shareholders’ funds 203,000

KK Ltd shares are trading at $140

KT Ltd $ ‘000’

Ordinary shares ($ 100 per value) 50,000

Share premium account 16,000

Profit and loss account 88,000

Shareholders’ funds 154,000

12% debentures (newly issued) 50,000

204,000

KT’s ordinary shares are trading at $170 and debentures at$ 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 by how much your financial position is expected to improve. Personal taxes may be ignored and the assumptions made by 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? (

(Total: 20 marks)