Question 2: Capital structure and dividend policy. 25 marks The following inform
ID: 2658630 • Letter: Q
Question
Question 2: Capital structure and dividend policy. 25 marks
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. (13 marks)
Cost of equity
20%
18%
Cost of debt
12%
-
Dividends
200 000
432 000
Interest
150 000
-
Shares
1000
1000
Explanation / Answer
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)
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