Question 2: Capital structure and dividend policy. 25 marks 1.1 The following in

Question

Question 2: Capital structure and dividend policy. 25 marks 1.1 The following information relates to two companies which trade in a Modigliani and Miller world:

Sanlam Santam

Cost of equity 20% 18% Cost of debt 12% - Dividends 200 000 432 000 Interest 150 000 - Shares 1000 1000

Required:

(a) Calculate the WACC for Sanlam and Santam. (4 marks) (b) Calculate the correct value for Sanlam shares assuming that Santam’s shares are correctly valued. (4 marks) (c) Explain what is meant by the term ‘arbitrage’ with reference to the M&M theory. (4 marks)

Explanation / Answer

Since the question is not that clear, I am making certain assumptions here

For Sanlam,

Cost of Equity = 20%

Cost of Debt = 12%

Dividends = 200,000

Interest = 150,000

Shares = 1000

For Santam,

Cost of Equtiy = 18%

There is no debt & hence no interest in this case

Dividends = 432,000

Shares = 1000

a) WACC for Sanlam = Weight of Equity*Return on Equity + Wd*Rd

Market Value of Equity = Dividends/Cost of Equity

MVe = 200,000/0.2 = 1,000,000

Market Value of Debt (MVd) = Interest / Cost of Debt = 150,000/0.12 = 1,250,000

We = MVe / (MVe + MVd) = 1000000/(1000000+1250000) = 0.44

Wd = 1-We = 0.56

WACC for Sanlam = 0.44*20 + 0.56*12 = 15.56 %

WACC fror Santam = Cost of Equity = 18% ----( Since it has no debt)

b)

Value of Sanlam Shares = MVe/1000 = 1000000/1000 = 1000

Value of Santam Shares = (432000/0.18)/1000 = 2400

c)

Arbitrage process is the operational justification for the Modigliani-Miller hypothesis. Arbitrage is the process of purchasing a security in a market where the price is low and selling it in a market where the price is higher. This results in restoration of equilibrium in the market price of a security asset. This process is a balancing operation which implies that a security cannot sell at different prices. The MM hypothesis states that the total value of homogeneous firms that differ only in leverage will not be different due to the arbitrage operation. Generally, investors will buy the shares of the firm that's price is lower and sell the shares of the firm that's price is higher. This process or this behavior of the investors will have the effect of increasing the price of the shares that is being purchased and decreasing the price of the shares that is being sold. This process will continue till the market prices of these two firms become equal or identical. Thus the arbitrage process drives the value of two homogeneous companies to equality that differs only in leverage.

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