Question 8.SE.5: Ashcroft plc, a family-controlled business, is considering r...
Ashcroft plc, a family-controlled business, is considering raising additional funds to modernise its factory. The scheme is expected to cost £2.34 million and will increase annual operating profits (profits before interest and tax) from 1 January Year 4 by £0.6 million. A summarised statement of financial position and an income statement are shown below. Currently the share price is 200p.
Two schemes have been suggested: (a) 1.3 million shares could be issued at 180p (net of issue costs); (b) a consortium of six City institutions has offered to buy loan notes from the business totalling £2.34 million. Interest would be at the rate of 13 per cent per year and capital repayments of equal annual instalments of £234,000 starting on 1 January Year 5 would be required.
| Statement of financial position as at 31 December Year 3 | |
| £m | |
| ASSETS | |
| Non-current assets | \underline{1.4} |
| Current assets | |
| Inventories | 2.4 |
| Trade receivables | \underline{2.2} |
| \underline{4.6} | |
| Total assets | \underline{6.0} |
| EQUITY AND LIABILITIES | |
| Equity | |
| Share capital, 25p ordinary shares | 1.0 |
| Retained earnings | \underline{1.5} |
| \underline{2.5} | |
| £m | |
| Current liabilities | |
| Trade payables | 3.2 |
| Tax due | \underline{0.3} |
| \underline{3.5} | |
| Total equity and liabilities | \underline{6.0} |
| Income statement for the year ended 31 December Year 3 | |
| £m | |
| terest payable | \underline{11.2} |
| Profit before taxation | 1.2 |
| Tax (25%) | \underline{(0.6)} |
| Profit for the year | \underline{0.6} |
Dividends of £0.3m were proposed and paid during the year. Assume tax is charged at the rate of 50 per cent.
Required:
(a) Compute the earnings per share for Year 4 under the loan notes and the ordinary share alternatives.
(b) Compute the level of operating profit (profit before interest and taxation) at which the earn-ings per share under the two schemes will be equal.
(c) Discuss the considerations the directors should take into account before deciding between loan notes or ordinary share finance.
Ashcroft plc
(a) The earnings per share for Year 4 for the loan notes and ordinary share alternatives are computed as follows:
| Loan notes £m |
Shares £m |
|
| Profit before interest and taxation | 1.80 | 1.80 |
| nterest payable | \underline{(0.30) } | \underline{(-) } |
| Profit before taxation | 1.50 | 1.80 |
| Tax | \underline{( 0.75) } | \underline{( 0.90) } |
| Profit for the year | 0.75 | 0.90 |
| Shares issued | 4.0m | 5.3m |
| EPS | \underline{ 18.75p} | \underline{ 17.0p} |
(b) Let X = the operating profit (profit before interest and taxation) at which the two schemes have equal EPS.
\begin{matrix}\text{Loan notes}&&\text{Shares}\\ \frac{(X − £0.3 m)(1 − 0.5)}{4.0 m}&=&\frac{X(1 − 0.5)}{5.3 m}\\(5.3 m X − £1.59 m)(1 − 0.5)&=&4.0 m X(1 − 0.5)\\0.65 m X&=&£0.795 m\\X&=&£1.223 m\end{matrix}
This could also be solved graphically as described in the chapter.
(c) The following factors should be taken into account:
● stability of sales and profits
● stability of cash flows
● interest cover and gearing levels
● ordinary share investors’ attitude towards risk
● dilution of control caused by new share issue
● security available to offer lenders
● effect on earnings per share and future cash flows.