- 20 Marks
FM – L2 – Q36 – Sources of finance: equity
Question
Brighton Enterprises wishes to expand its production facilities to meet an increase in sales demand for its products. It will need GH₵18 million of new capital to invest in equipment. It is expected that annual profit before interest and taxation will increase by GH₵5 million.
Brighton Enterprises is considering the following three possible methods of financing the expansion programme:
(i) Issuing 9 million GH₵0.50 equity shares at a premium of GH₵1.50 per share.
(ii) Issuing 12 million 12% GH₵1 preference shares at par and GH₵6 million 10% debentures at par.
(iii) Issuing 6 million equity shares at a premium of GH₵1.50 per share and GH₵6 million 10% debentures at par.
Assume that the rate of tax on profits is 25%.
The statement of financial position of Brighton Enterprises as at 31st November Year 6 is as follows:
Statement of financial position as at 30th November Year 6
| GH₵m | GH₵m | |
|---|---|---|
| Non-current assets | 24.8 | |
| Current assets | ||
| Inventory | 18.5 | |
| Trade receivables | 21.4 | |
| Bank | 1.9 | |
| 41.8 | ||
| Total assets | 66.6 | |
| Equity and liabilities | ||
| GH₵0.50 ordinary shares | 10.0 | |
| Accumulated profits | 22.4 | |
| Total equity | 32.4 | |
| 10% Debentures | 15.0 | |
| Current liabilities | ||
| Trade payables | ||
| Taxation | ||
| 19.2 | ||
| Total equity and liabilities | 66.6 |
A statement of profit or loss for the year to 30th November Year 6 is as follows:
| GH₵m | |
|---|---|
| Sales | 115.4 |
| Profit before interest and taxation | 17.9 |
| Interest payable | 1.5 |
| Profit before taxation | 16.4 |
| Tax (25%) | 4.1 |
| Profit after taxation | 12.3 |
Required
(a) For each of the financing schemes under consideration:
(i) prepare a projected statement of profit or loss for the year ended 30 November Year 7.
(ii) calculate the expected earnings per share for the year ended 30th November Year 7.
(iii) calculate the expected level of financial gearing as at 30th November Year 7, assuming that dividend payments during the year are GH₵0.30 per share.
(b) Assess each of the three financing schemes under consideration from the viewpoint of an existing equity shareholder in Brighton Enterprises.
Answer
(a) Projected statements of profit or loss for the year ended 30th November
Financing method
| i | ii | iii | |
|---|---|---|---|
| GH₵m | GH₵m | GH₵m | |
| Profit before interest and tax: | |||
| (17.9 + 5.0) | 22.9 | 22.9 | 22.9 |
| Interest payable | 1.5 | 2.1 | 2.1 |
| Profit before tax | 21.4 | 20.8 | 20.8 |
| Taxation (25%) | 5.4 | 5.2 | 5.2 |
| Profit after tax | 16.0 | 15.6 | 15.6 |
| Preference dividend | 0.0 | 1.4 | 0.0 |
| Profit available to equity | 16.0 | 14.2 | 15.6 |
| Number of shares | (20.0 + 9.0) | (20.0 + 6.0) | |
| 29.0m | 20.0m | 26.0m | |
| Earnings per share = | GH₵0.552 | GH₵0.71 | GH₵0.60 |
| GH₵m | GH₵m | GH₵m | |
| Accumulated profit at beginning of the year | 17.8 | 17.8 | 17.8 |
| Profit available to equity for the year | 16.0 | 14.2 | 15.6 |
| Dividend payments (GH₵0.30 per share) | (8.7) | (6.0) | (7.8) |
| Accumulated profit at end of the year | 25.1 | 26.0 | 25.6 |
| Equity shares | 14.5 | 10.0 | 13.0 |
| Share premium | 13.5 | 0.0 | 9.0 |
| General reserve | 4.6 | 4.6 | 4.6 |
| Total share capital and reserves | 57.7 | 40.6 | 52.2 |
| Fixed rate long-term capital: | |||
| 10% debentures | 15.0 | 21.0 | 21.0 |
| Preference shares | 0.0 | 12.0 | 0.0 |
| Total long-term capital | 72.7 | 73.6 | 73.2 |
| Gearing | 15.0 / 72.7 | 33.0 / 73.6 | 21.0 / 73.2 |
| = | 20.6% | 44.8% | 28.7% |
Other methods of calculating the gearing ratio would be acceptable.
(b) Financing scheme (i) produces the lowest EPS of the three options. This EPS is also lower than the current EPS of GH₵0.615.
Financing scheme (ii) produces the highest EPS. It is also the only option that produces a higher EPS than the current EPS. However, the gearing ratio is substantially higher than the current gearing ratio or the gearing ratios of the other options. The projected statements of profit or loss show a high level of coverage for interest payments under this option and therefore the relatively high level of gearing is unlikely to be a problem.
Financing option (iii) produces an EPS that is lower than the current EPS and lower than the EPS of option (ii). However, the gearing ratio is fairly low, indicating a relatively low level of financial risk.
- Topic: Sources of finance: equity
- Uploader: Samuel Duah