Question 1 (30 marks)
a) Define and distinguish the following: (10 marks)
i. Gearing ratio and asset protection ratio
ii. Financial distress and insolvency
iii. Acquisition and a takeover
iv. Liquidation and reorganizational of a company
v. Proxy contest and going private
b) Using the balance sheet of a firm, explain the difference between valuation and financing. (5 marks)
c) Differentiate between the static tradeoff and the pecking order hypothesis of capital structure. In each case, list he basic assumptions. (6 marks)
d) Jambo Ltd is a new player in the telecommunication industry offering resale services. The company is fully financed by its shareholders. It expects to generate Kshs. 500, 000 in earnings before interest and taxes (EBIT) in perpetuity. The corporate tax rate is 25% and all earnings after tax are to be paid out s dividends. The shareholders have approved for a capital restructuring to allow Kshs. 1, 000, 000 of debt, payable at 25% interest rate. The cost of equity capital of companies in the same industry is 20%.
i. What is the value of the unlevered firm? (2 marks)
ii. What will be the new value of the company after restructuring? (7 marks)
Question 2 (20 marks)
a) What is the Modiglian-Miller “Irrelevance Theorem of capital structure? (5 marks)
b) Differentiate between MM proposition I and MM proposition II (Use diagrams where necessary) (6 marks).
c) i) What is the implication of MM proposition I and II for working average cost of capital (WACC). (2 marks).
ii) Starting from the WACC in the case of MM proposition, derive the WACC for MM proposition II. (7 marks).
Question 3 (20 marks)
a) What is dividend policy? (3 marks)
b) Briefly discuss the three major theories on dividend policy. (12 marks)
c) How does tax affect dividend policy? (5 marks)
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