Question

QUESTION ONE (a) Two firms Alusunge Construction Limited (ACL) and Banja Corporation Limited (BCL) need to raise finance. ACL is in high-growth construction business with good prospects for future projects. The business is volatile and cash flows are difficult to predict. On the other hand BCL operates in a stable mature petroleum industry (i) All else being equal, which firm should borrow more, and why? (ii) Consider company ACL only. The owners hold 55% of the issued share capital. How does this affect the decision to raise funds through equity? (5 marks) (7 marks) (b) HPT Resources Limited provides telephone services over the internet. The company expects that its capital expenditure will amount to K40 million. The company's net income after tax is K32.4 million. The company follows the residual approach to dividends. The company's target capital structure is represented by a debt to equity ratio of 3:5. Determine the company's dividend pay-out ratio. (13 marks) Total (25 marks)

Answer 1

Answer (a)

i) ACL is a budding firm with a promising future although the cash flows are hardly predictable, the future is bright. The company needs fund at the initial stages to survive such inconsistencies and hence requires to borrow funds comparatively at a higher rate when compared to a company such as BCL. Since BCL is well established and doesn't require ample amounts of fund to carry on their business it would be unwise to borrow money on a large scale as the growth can be achieved with lesser funds from outside and more from the inside of the firm.

ii) The ACL's owner holds a 55% of the share equity shows the trust of the owner in the company. The company can easily issue equity shares and yet keep the majority stake and hold the decision card. The company needs a firm ownership and by having more than half of the company's stake the owner displays great trust in the company. The dilution of some of the owner's stake is inevitable as the company requires funds from the equity market. But the sharing percentage shows great deal of faith from the owner in the company.

(b) The company's dividend payout ratio is formulated by Dividend /Net Income. The details provided shows a net income of 32.4 million. The standard rate of providing dividends is a year. The expected expenditure is higher than what the company has earned and being adopted residual approach the dividends might not be provided the following year due to more expenses.

However, if we determine try and determine the dividend payout ratio with the information provided in the question, the solution is explained below -

If the company's net income is 32.4 Million and company decides a 3:5 targeted debt to equity ratio. The residual theory suggests the calculation of the dividend is Net Income - (targeted debt to equity ratio) *(Total Expenditure) *T, "T" is time, we assume it to be 1 year

Putting values - 32.4 Million - (3/5) * (40 Million) * 1

Gives us - 8.4 Million of dividend,

Dividend pay out ratio is - Dividends/ Net income

Putting values - 8.4 Million/ 32.4 Million

Which gives us - 0.259 or 25.9% which is the Dividend Payout Ratio.