Question

Question 2: Capital structure and dividend policy.         

The following information relates to two companies which trade in a Modigliani and Miller world:

Sanlam                          Santam

Cost of equity	20%	18%
Cost of debt	12%	-
Dividends	200 000	432 000
Interest	150 000	-
Shares	1000	1000

Suppose Sanlam ltd wishes to finance a major restructuring project whose total cost is N$75 Million. The company follows a residual policy on dividends. Earnings for the coming year are expected to be N$60 Million and the company maintains a debt to equity ratio of 0.5 (50%). An extract from the statements of financial position is shownbelow:

Statement of Financial position extract:   2018                           2017

Equity: Ordinary shares of N$0.50 each        N$5 000 000          N$5 000 000

 

Calculate the following:

I).dividend per share;

ii).the value of additional debt, and

iii).ordinary share capital to be raised in order to finance the restructuring project.        

Answer 1

Given,

Dividends = $200,000

Shares = 1000

Therefore,

Dividend per share =$ (200,000/1000) =$200       Answer (i)

Given,

Equity of the company = $5 million

Cost of Debt =12%

Interest = $150,000

Therefore,

Debt of the company =$ (150,000/12%) =$1.25 million

Now,

Expected earning of the company =$60 million

Cost of the major restructuring project= $75 million

As per residual dividend policy,

The remaining amount to be financed by debt and equity = $(75-60) million =$15million

If we assume, the amount to be financed by Debt = $ a million

Then, the amount to be financed by Equity= $ (15-a) million

So to maintain the Debt/Equity ratio 0.5, we can form the equation:

(1.25+a)/(5+15-a) = 0.5

Solving this equation we can get:

a = 5.83

Therefore,

The value of additional debt = $ 5.83 million                Answer (ii)

Ordinary share capital to be raised in order to finance the project = $(15-5.83) million

                                                                                                        =$9.17 million Answer (iii)