- 20 Marks
Question
Tope operates a chain of cellular telephone stores in the country. An abbreviated profit or loss account and statement of financial position of the business for the year that has just ended is as follows:
Abbreviated profit or loss account for the year ended 31 May 2023
| ₦‟000 | |
|---|---|
| Sales | 6,450 |
| Operating profit for the year | 800 |
| Interest payable | (160) |
| Net profit before taxation | 640 |
| Tax (20%) | (128) |
| Net profit after taxation | 512 |
| Dividends proposed | (256) |
| Retained profit for the year | 256 |
Abbreviated statement of financial position as at 31 May 2023
| ₦‟000 | ₦‟000 | |
|---|---|---|
| Non-current assets at written down values | 3,500 | |
| Current assets | 1,800 | |
| Less: Current liabilities | (1,100) | 700 |
| 4,200 | ||
| Less: long-term liabilities | (2,000) | |
| 2,200 | ||
| Capital and reserves | ||
| ₦0.50 ordinary shares | 600 | |
| Retained profit | 1,600 | |
| 2,200 |
The company is expecting a surge in sales following advances in cellular telephone technology that should translate into additional operating profits of ₦180,000 per year for the foreseeable future. However, the company will need to invest ₦1,200,000 immediately in expanding the asset base of the business, if it is to achieve these additional profits.
The business has approached a large supplier that already has an equity investment in the business to see whether it would be prepared to provide further funds for the business. The supplier has indicated it would be willing to provide the necessary funds by either:
(i) An issue of ₦0.50 ordinary shares at a premium of ₦1.50 per share; or
(ii) An issue of ₦1,200,000 10% debt at par.
The Board of Directors of Tope has already announced that it will maintain the same dividend payout ratio in future years as in the past and that this policy will be unaffected by the form of finance raised.
Required:
a. For each of the financing options:
i. Prepare a forecast profit or loss account for the forthcoming year.
(5 Marks)
ii. Calculate the forecast earnings per share for the forthcoming year.
(2 Marks)
iii. Calculate the projected level of gearing (D/(D+E)) at the end of the forthcoming year. (2 Marks)
b. Calculate the level of operating profit at which the earnings per share will be the same under each financing option. (3 Marks)
c. Evaluate each of the financing options from the view point of an existing shareholder. (2 Marks)
d. Discuss the factors that will influence a company to finance through debt or equity, and whether to opt for long-term or short-term debt. (6 Marks)
Answer
a. (i) Forecast profit or loss account
Option (i) Equity:
Operating profit = 800 + 180 = 980
Interest = 160
PBT = 820
Tax 20% = 164
PAT = 656
Dividend 50% = 328
Retained = 328
Option (ii) Debt:
Operating profit = 980
Interest = 160 + 120 = 280
PBT = 700
Tax = 140
PAT = 560
Dividend 50% = 280
Retained = 280
(5 Marks)
ii. Forecast EPS
Option (i): Shares = 600k / 0.5 = 1,200k new shares = 1,200k / 0.5 = 2,400k total shares = 3,600k
EPS = 656k / 3,600k = ₦0.18
Option (ii): Shares remain 1,200k
EPS = 560k / 1,200k = ₦0.47
(2 Marks)
iii. Projected gearing
Option (i): Debt 2,000k, Equity 2,200k + 1,200k = 3,400k, Gearing = 2,000 / (2,000 + 3,400) = 37%
Option (ii): Debt 2,000 + 1,200 = 3,200k, Equity 2,200k, Gearing = 3,200 / (3,200 + 2,200) = 59%
(2 Marks)
b. Indifference level of operating profit
Let OP = x
For equity: PAT = 0.8 (x – 160), EPS = 0.8 (x – 160) / 3,600k *1,000 = 0.000222 (x – 160)
For debt: PAT = 0.8 (x – 280), EPS = 0.8 (x – 280) / 1,200k *1,000 = 0.000667 (x – 280)
Set equal: 0.000222 (x – 160) = 0.000667 (x – 280)
x – 160 = 3 (x – 280)
x – 160 = 3x – 840
2x = 680
x = 340k
(3 Marks)
c. Evaluation from existing shareholder viewpoint
Equity: Dilutes EPS from 0.43 to 0.18, lower returns.
Debt: Higher EPS 0.47 > 0.43, but higher gearing risk.
Debt preferred if OP > 340k.
(2 Marks)
d. Factors influencing debt or equity, long or short-term debt
Debt vs Equity: Tax shield (debt), bankruptcy risk (debt), control (equity), cost (debt cheaper).
Long vs Short: Matching principle, interest rate risk (short), refinancing risk (short), flexibility (short).
(6 Marks)
- Topic: Capital Structure Decisions
- Series: MAY 2024
- Uploader: Samuel Duah