- 15 Marks
FM – FM – L2 – Q35 – Capital structure
Question
The following information is available about Company A and Company B:
| Company A | Company B | |
|---|---|---|
| Capital structure | GH¢ | GH¢ |
| Equity shares of GH¢1 | 10,000 | 10,000 |
| Reserves | 20,000 | 90,000 |
| 10% debt capital | 30,000 | — |
| 60,000 | 100,000 | |
| 100,000 | 100,000 |
| Annual profit | | | | Sales | 80,000 | 80,000 |
| Variable costs | 40,000 | 40,000 |
| Contribution | 40,000 | 40,000 |
| Fixed operating costs | 10,000 | 10,000 |
| Profit before interest and tax | 30,000 | 30,000 |
| Interest costs | 3,000 | — | | Profit | 27,000 | 30,000 |
| Tax (20%) | 5,400 | 6,000 |
| Profit after tax (= earnings after interest and tax) | 21,600 | 24,000 |
Required:
(a) Calculate the earnings per share for Company A and Company B.
(b) Calculate the level of profit before interest and tax at which the earnings per share for Company A will be equal to the earnings per share for Company B.
(c) Comment on the financial risk in Company A and Company B.
Answer
(a) Earnings per share
| Company A | Company B | |
|---|---|---|
| Profit after tax | GH¢21,600 | GH¢24,000 |
| Number of shares | 10,000 | 10,000 |
| Earnings per share | GH¢2.16 | GH¢2.40 |
(b) Level of profit before interest and tax at which EPS for Company A = EPS for Company B
Let P = profit before interest and tax.
Company A:
Profit before tax = P – 3,000
Profit after tax = (P – 3,000) × 80%
EPS = [(P – 3,000) × 0.8] / 10,000
Company B:
Profit before tax = P
Profit after tax = P × 80%
EPS = (P × 0.8) / 10,000
For EPS to be equal:
[(P – 3,000) × 0.8] / 10,000 = (P × 0.8) / 10,000
P – 3,000 = P
This equation has no solution, which suggests that there is no level of profit before interest and tax at which the EPS for the two companies would be equal, because Company A always has interest of GH¢3,000 to pay, whereas Company B has no interest cost.
(c) Comment on financial risk
Financial risk is higher in Company A than in Company B. This is because Company A is geared, with GH¢30,000 of debt capital in its capital structure, whereas Company B is ungeared.
The gearing in Company A means that there is a fixed interest cost of GH¢3,000 each year, which must be paid before shareholders receive any return. If the profit before interest and tax were to fall below GH¢3,000, Company A would be unable to pay the interest, whereas Company B would still have some profit to distribute to shareholders.
The gearing ratio for Company A is 30,000 / 100,000 = 30%. This is not a high level of gearing, and the interest cover is 30,000 / 3,000 = 10 times, which is high. This suggests that the financial risk in Company A is not excessive. However, it is still higher than in Company B, which has no financial risk from gearing.
- Tags: Capital structure, Debt, Earnings per share, Equity, Financial Risk, Gearing, Profit after tax
- Level: Level 2
- Topic: Capital structure
- Uploader: Samuel Duah