Financial gearing

FM – L2 – Q39 – Cost of capital

Calculate change in EPS for Kwadu Cocoa Plc after introducing a new production process with increased fixed costs and reduced variable costs, financed by debentures.

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

Find Related Questions by Tags, levels, etc.

Tags: Capital structure, Combined gearing, Financial gearing, Financial Risk, Operating gearing
Level: Level 2

Topic: Capital structure

FM – L2 – Q36 – Sources of finance: equity

Prepare profit/loss statements, calculate EPS, and determine gearing for three financing schemes for Brighton Enterprises' expansion.

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

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Tags: Debt financing, Earnings per share, Equity financing, Financial gearing, Financing schemes, Shareholder perspective
Level: Level 2

Topic: Sources of finance: equity

Tag (SQ): Financial gearing

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FM – L2 – Q39 – Cost of capital

Calculate change in EPS for Kwadu Cocoa Plc after introducing a new production process with increased fixed costs and reduced variable costs, financed by debentures.

FM – L2 – Q36 – Sources of finance: equity

Prepare profit/loss statements, calculate EPS, and determine gearing for three financing schemes for Brighton Enterprises' expansion.

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FM – L2 – Q39 – Cost of capital

Calculate change in EPS for Kwadu Cocoa Plc after introducing a new production process with increased fixed costs and reduced variable costs, financed by debentures.

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FM – L2 – Q36 – Sources of finance: equity

Prepare profit/loss statements, calculate EPS, and determine gearing for three financing schemes for Brighton Enterprises' expansion.

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