Question two

a)GK and FF 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 structure is summarized below:

GK 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

GK Ltd shares are trading at Kshs 140.

FF 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

FF Ltd ordinary shares are trading at Ksh 170 and debentures at Kshs 100.Annual earnings before interest and tax for each company is 50 million. Corporation tax rate is 30%.

Required

1. If you own 4% of the ordinary shares of FF Ltd and you agree with the arguments of Modigliani and miller, explain what action you take to improve your financial position.

1. Explain how much your financial position is expected to improve. Personal taxes may be ignored and MM Assumptions may be used.

1. If GK Ltd were to borrow Kshs 40 million, compute and explain the effect this will have on the companys cost of capital according to MM. What implications would this suggest for the companys choice of capital structure