CORPORATE FINANCE

QUESTION ONE
a) Discuss how agency theory explains the relationship between the management and shareholders of a corporation. (5 marks)
(b) How is wealth maximization as a goal of the corporate firm consistent with agency theory? (6 marks)
(c) Is it true under agency theory that a corporate manager will always undertake projects with positive net present value, under conditions of no capital rationing? Explain. (6 marks)
d) Consider two investments, A and B each having the following investment characteristics;
INVESTMENT
EXPECTED RETURN (%)
PROPOTION
A
10
2/3
B
20
1/3
REQUIRED:
Compute the expected return of a portfolio of the two assets. (4 marks)
d) Differentiate between bonds and debentures. (4 marks)
QUESTION TWO
a) Discuss five factors to be considered when making capital structure decisions (5 marks)
b) Bidii limited has a cost of capital of 10%. The company currently has 250,000 shares outstanding and selling on the stock exchange at sh 120 per share. The companys earning per share is sh.10 and intends to maintain a dividend payout ratio of 50% at the end of the current financial year. The companys expected income for the current year is sh. 3million and the available investment proposals are estimated at cost sh. 6 million.
Required: Using the Modigliani and Miller model, show that the payment of dividends does not affect the value of the firm. (10 marks)
4
QUESTION THREE
Companies U and L are identical in every respect except that U is unlevered while L has Sh 10 million of 5% bonds outstanding. Assume
(a) That all of the MM assumptions are met
(b) That there are no corporate or personal taxes
(c) That EBIT is Sh 2 million
(d) That the cost of equity to company U is 10%
Required:
i) Determine the value MM would estimate for each firm (4 marks)
ii) Determine the cost of equity for both firms (4 marks)
iii) What is the overall cost of capital for both firms? (3 marks)
iv) Suppose the value of U is Sh 20 million and that of L is Sh 22 million. Explain the arbitrage process for a sh.