QUESTION 4 a) Differentiate between short-term and long-term lease (5 marks) b)

Question

QUESTION 4
a) Differentiate between short-term and long-term lease (5 marks)
b) Given: Need $72 million for new investments; Target capital structure D/E =3/4;
Net Income = $75 Million. Find out the amount of dividends that can be paid under
a Residual Dividend Policy? (5 marks)
c) Based on M & M with taxes and without taxes, how much time should a financial
manager spend analyzing the capital structure of their firm? What if the analysis is
based on the static theory which takes into account the financial distress cost?
(2 + 3 = 5 marks)
d) ABC Inc’s total value of capital is $4,500,000. Its cost of Equity is 15 percent and
the cost of debt is 8 percent. Its capital structure is $2,500,000 in Equity and
$2,000,000 in debt. What is its WACC? (5 marks)

Explanation / Answer

a) Time period - short-term lease time period is five years or less, whereas long-term lease time period is five years or more

Nature of lease - short-term lease time period is flexible that is easy selection or termination for tenant, whereas long-term lease time period is rigid in nature.

Stability - long-term lease gives better stability for tenant to stay at a specific place for many years, whereas short term lease ,there is lack of stability

Maintenance and repair cost - For longer period of staying in long term lease may give high maintenance and repair costs , whereas for short term lease due to frequent changing location may give lower maintenance and repair costs .

b) Amount of dividends that can be paid under a Residual Dividend Policy :

     Dividend = net income - [equity ratio * capital investment]

Dividend = $75000000 - [ 0.5714 * $72000000]

Dividend = $75000000 - $41140800

Dividend = $33859200

Note:- D/E = 0.75 , where debt = 0.75 , equity = 1 and total value = 1.75 ,

Equity ratio = Tota equity / [Total equity + total debt]

Equity ratio = 1 / 1.75

    Equity ratio = 0.5714

(c)   Based on M & M with taxes and without taxes, no time should be invested by financial manager in order to analyse the capital structure of their firm because in case of with taxes ,capital structure as 100% of debt (no equity) is required to maximise the value of firm and consideration on percentage portion of equity and debt is not necessary in capital structure in case of without taxes

(d) WACC = Equity / [Debt + equit y] * cost of equity + Debt / [debt + equity] * cost of debt

WACC = $2,500,000  / [$2,000,000 + $2,500,000 ] * 15% + $2,000,000/ [$2,000,000 + $2,500,000 ] * 8%

WACC = $2,500,000  / $4500000 * 15% + $2,000,000/ $4500000 * 8%

WACC =8.33% + 3.56%

WACC = 11.89%

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