- 15 Marks
FM – L2 – Q39 – Cost of capital
Question
Kwadu Cocoa Plc produces and sells a single product. The company has issued share capital of 800,000 equity shares of GH₵1 each. For the year ended 31st March Year 4, the company sold 60,000 units of the product at a price of GH₵30 each.
The statement of profit or loss for the year to 31st March Year 4 is as follows:
| GH₵’000 | GH₵’000 | |
|---|---|---|
| Sales | 1,800 | |
| Variable costs | 720 | |
| Fixed costs | 360 | |
| 1,080 | ||
| Net profit before interest and tax | 720 | |
| Minus interest payable | 190 | |
| Net profit before tax | 530 | |
| Tax at 35% | 186 | |
| Net profit after tax | 344 |
The company has decided to introduce a new automated production process, in order to improve efficiency. The new process will increase annual fixed costs by GH₵120,000 (including depreciation) but will reduce variable costs by GH₵7 per unit. There will be no increase in annual sales volume.
The new production process will be financed by the issue of GH₵2,000,000 12.5% debentures.
Required:
(a) Calculate the change in earnings per share if the company introduces the new production process.
(b) Assume that the company introduces the new production process immediately on 1st April Year 5. Calculate for the year to 31st March Year 5:
(i) the degree of operating gearing
(ii) the degree of financial gearing
(iii) the combined gearing effect.
Answer
(a) Existing earnings per share =
Net profit after tax / Number of equity shares
= GH₵344,000 / 800,000 = GH₵0.43
Earnings per share with new production process:
| GH₵’000 | GH₵’000 | |
|---|---|---|
| Sales (60,000 × GH₵30) | 1,800 | |
| Variable costs (60,000 × (GH₵12 – GH₵7)) | 300 | |
| Fixed costs (GH₵360,000 + GH₵120,000) | 480 | |
| 780 | ||
| Net profit before interest and tax | 1,020 | |
| Interest payable: | ||
| Existing (GH₵190,000) | 190 | |
| New debentures (GH₵2,000,000 × 12.5%) | 250 | |
| Total interest | 440 | |
| Net profit before tax | 580 | |
| Tax at 35% | 203 | |
| Net profit after tax | 377 |
Earnings per share = GH₵377,000 / 800,000 = GH₵0.47125
Change in EPS = GH₵0.47125 – GH₵0.43 = GH₵0.04125
(b) From (a) above:
Contribution = Sales – Variable costs = GH₵1,800,000 – GH₵300,000 = GH₵1,500,000
Profit before interest and tax = GH₵1,020,000
Profit after tax = GH₵377,000
(i) Degree of operating gearing = Contribution / Profit before interest and tax
= GH₵1,500,000 / GH₵1,020,000 = 1.47
(ii) Degree of financial gearing = Profit before interest and tax / Profit after tax
= GH₵1,020,000 / GH₵377,000 = 2.71
(iii) Combined gearing effect = Operating gearing × Financial gearing
= 1.47 × 2.71 = 3.98
- Tags: Capital structure, Combined gearing, Financial gearing, Financial Risk, Operating gearing
- Level: Level 2
- Topic: Capital structure
- Uploader: Samuel Duah