Question

Question 2: Capital structure and dividend policy. 25 marks
1.1 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
Required:
(a) Calculate the WACC for Sanlam and Santam.
(b) Calculate the correct value for Sanlam shares assuming that Santam’s shares are correctly valued.
(c) Explain what is meant by the term ‘arbitrage’ with reference to the M&M theory.

1.2 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 shown below:
Statement of Financial position extract: 2018 2017
Equity: Ordinary shares of N$0.50 each N$5 000 000 N$5 000 000

Required:
(a) 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

Particulars	Sanlam	Santam
Cost of equity	20%	18%
Cost f debt	12%	0
Dividends	200000	432000
Interest	150000	0
Shares	1000	1000

Share Capital                     Sanlam=200000/20%=1000,000

                                                Santam=432000/18%=2400,000

Debt Fund                        Sanlam=150000/12%=1250,000

                                                Santam =0

                                                 

Total Capital                     Sanlam =1000,000 +1250,000=2250,000

                                                  Santam=2400,000

a.Wieghted Average of capital

Formula= Cost of Equity* % of Equity +Cost of debt*% of debt(1-t)

Sanlam Company

Cost of Equity=Given =20%

% of equity=Equity Value/Total Capital

                     1000,000/2250,000=0.44

Cost of debt=Given=12%

% of Debt=Debt /Total Capital=1250,000/2250,000=0.56

WACC of Sanlam=0.44*20% +0.56(1-0)*12%=0.1552=15.52%

Santam Company =1*18%+0(1-0)*0=18%

b.Value of Shares=Total Equity Value /No of shares

Sanlam=1000,000/1000=1000/-

Santam=2400,000/1000=2400/-

(c) Explain what is meant by the term ‘arbitrage’ with reference to the M&M theory.

Ans: Arbitrage refers to Buying the share at lowest at one market and selling at the market where the price is higher i.e nothing but buying at low and sell at high ,,that means encashing the difference value.

As per M&M theory Suggests ,For valuing the firm ,it is irrelevant to calculate the capital structure of the firm but provided the conditions of M&M such as No taxes and No trasactions costs and Borrowing costs should be same on both equity and debt, All these conditions must fulfil , fulfilling these conditions, these days is very difficult because almost every good economy collect taxes.

Because some of the investors buy the shares of the company where debt is less because debt leads to immediate payment of cash,which leads to cash outlay and reduce the net profits ,,If debt is less then the retained earnings will keep grow as a consequence ,The price of Equity share get grow in long run because of retained earnings which help in further investment.

(a) Calculate the following:

1.dividend per share: Divided/No of Shares=200000/1000 shares=100/ per day

2.the value of additional debt

Debt/Equity ratio=0.50 , total debt/total equity =0.5 = i.e ½=0.50 i.e Debt 1 time and Equity is 2 times

Therefore total funds required is 75 million out of which 60 millions revenue will be generated and remaining funds to be raised is 15 millions in the ratio of 1:2

I.e Debt=5 Millions and

Equity =10 Millions

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

Ordinary shares of N$0.50 each

10 millions/0.50=20 Million shares having par value of $0.5 shall be issued