Carbon and Short plc both operate in the same industry with the same

business risk. Their earnings, capital structure, share prices and other data

are as follows:

Carbon plc Short plc

Sh 000 Sh 000

Annual operating income 50,000 100,000

Annual interest nil 20,000

Annual cash flow 50,000 120,000

Equity market value 312,500 600,000

Debt market value nil 200,000

Total market value 312,500 800,000

Cost of equity capital 16% 16.6%

Cost of debt capital 10.0%

WACC 16% 15.0%

No. of shares in issue 3.25m 5m

Market price per share Sh96 Sh120 Kitson holds Sh 100,000 worth of shares in Short and can borrow at the

rate as Short. Show how Kitson can increase his wealth through arbitrage.

Ignore taxes and transaction costs.

Q4.(b) You are given the following details about Facts of Life plc. Breakdown of activities by percentage of total annual company turnover:

Department stores: 30% Clothing: 24% Building materials: 20% Hotels and catering: 16% Electronics: 10% Current share price: Sh 234

Average annual share price growth over the past five years: 5%

Sector average annual share price growth over the past 5 years: 9%

Level of gearing based on market values (debt/debt+equity) 23%

Sector gearing level based on market values (debt/debt+equity) 52% The directors of the company were given share options by its

remuneration committee five years ago. In a years time the options will

allow each director to purchase 100 000 shares in the company at a price

of Sh 200.00.

The directors average annual salary currently stands at Sh 20,000,000 on a

five-year rolling contract basis, while average salaries in the conglomerate

sector are Sh15,000,000 and tend to be three-year rolling contracts. (a) Using the above information to illustrate your answer, critically discuss

the extent to which Facts of Life plc can be said to be suffering from the

agency problem.

(b) Discuss how the issues you have identified in part (a) can be

addressed in order to reduce the agency problem.