KK and KT Ltd are two companies in the printing industry. The companies have the same business risk and are almost identical in all respects expect for their capital structures and market values. The companies' capital structures are summarized below:

KK Ltd

KShs. '000

Ordinary shares (KShs. 50 par value)

40,000

Share Premium Account

90,000

Profit and Loss Account

73,000

Shareholders' funds

203,000

KK Ltd shares are trading at KShs. 140

KT Ltd

KShs. '000

Ordinary shares (KShs. 100 par value )

50,000

Share Premium Account

16,000

Profit and Loss Account

88,000

Shareholders funds

154,000

12% debentures (newly issued)

50,000

204,000

KT Ltd ordinary shares are trading at KShs. 170 and debentures at KShs. 100. Annual Earnings Before Interest and Tax for each company is KShs. 50 million. Corporation tax is at the rate of 30%.

Required:

1. If you owned 4% of the ordinary shares of KT Ltd, and you agree with the arguments of Modigliani and Miller, explain what action you would take to improve your financial position.
2. Explain how much your financial position is expected to improve. Personal taxes may be ignored and the assumptions made by Modigliani and Miller may be used.
3. If KK Ltd were to borrow KShs. 40 million, compute and explain the effect this would have on the company's cost of capital according to Modigliani and Miller. What implications would this suggest for the company's choice of capital structure?