Question

Karim plc and Roshan plc are quoted companies. The following figures are from their current
balance sheets.
Karim plc Roshan plc
GHC, 000 GHC, 000
Ordinary share capital
Authorized: 2,000,000 shares of 50p 1,000 1,000
Issued: 1,000,000 shares of 50p 500 500
Reserves 1,750 150
SHAREHOLDERS FUNDS 2,250 650
6% Irredeemable debentures - 2,500
Both companies earn an annual profit, before charging debenture interest, of GHC 500,000 which
is expected to remain constant for the indefinite future. The profits of both companies before
charging debenture interest, are generally regarded as being subject to identical levels of risk. It
is policy of both companies to distribute available profits as dividends at the end of each year.
The current market value of Karim plc’s ordinary shares is GHC 3.00 per share cum div. An annual
dividend is due to be paid in the very near future.

Roshan plc’s has just made annual dividend and interest payments both on its ordinary shares
and debentures. The current market value of the ordinary is GHc 1.40 per share and of the
debentures GHC 50.00 per cent.
Mr Hashim owns 50,000 ordinary shares in Roshan plc. He is wondering whether he could
increase his annual income, without incurring extra risk, by selling his shares in Roshan plc and
buying some of the ordinary shares of Karim plc. Mr Hashim is able borrow money at an annual
compound rate of interest of 12%.
You are required to do the following:
a. Estimate the cost of ordinary share capital and the weighted average cost of capital of
Karim plc and Roshan plc.
b. Explain briefly why both the cost of ordinary share capital and weighted average cost of
capital of Karim plc differ from those of Roshan plc
c. Prepare calculations to demonstrate to Mr Hashim how he might improve his position in
the way he suggested, starting clearly any reservation you have about the scheme
d. Discuss any implications of your answer to (a), (b) and (c) above for the determination of
a company’s optimal financial structure in practices
Ignore taxation for (a) (b), (c) but not for (d)