Question 8.S-AQ.1: Russell Ltd instals and services heating and ventilation sys...
Russell Ltd instals and services heating and ventilation systems for commercial premises.
The most recent financial statements of the business are set out below:
| Statement of financial position as at 31 May Year 4 | |
| £000 | |
| ASSETS | |
| Non-current assets | |
| Machinery and equipment | 555.2 |
| Motor vehicles | \underline{186.6} |
| \underline{741.8} | |
| Current assets | |
| Inventories | 293.2 |
| Trade receivables | 510.3 |
| Cash at bank | \underline{18.4} |
| \underline{821.9} | |
| Total assets | \underline{1,563.7} |
| £000 | |
| EQUITY AND LIABILITIES | |
| Equity | |
| £1 ordinary shares | 400.0 |
| General reserve | 52.2 |
| Retained earnings | \underline{380.2} |
| \underline{832.4} | |
| Non-current liabilities | |
| 12% loan notes (repayable Year 10/11) | \underline{250.0} |
| Current liabilities | |
| Trade payables | 417.3 |
| Tax due | \underline{64.0} |
| \underline{481.3} | |
| Total equity and liabilities | \underline{1,563.70} |
| Income statement for the year ended 31 May Year 4 | |
| £000 | |
| Sales revenue | \underline{5,207.80} |
| Operating profit (profit before interest and taxation) | 542.0 |
| Interest payable | \underline{(30.0)} |
| Profit before taxation | 512.0 |
| Tax (25%) | \underline{(128.0)} |
| Profit for the year | \underline{384.0} |
A dividend of £153,600 was proposed and paid during the year.
The business wishes to invest in more machinery and equipment in order to cope with an upsurge in demand for its services. Additional operating profit (profit before interest and taxation) of £120,000 per year is expected if an investment of £600,000 is made in plant and machinery.
The directors of the business are considering an offer from a private equity firm to finance the expansion programme. The finance will be made available immediately through either:
(i) an issue of £1 ordinary shares at a premium on nominal value of £3 per share, or
(ii) an issue of £600,000 10% loan notes at nominal value.
The directors of the business wish to maintain the same dividend payout ratio in future years as in past years, whichever method of finance is chosen.
Required:
(a) For each of the financing schemes:
(i) Prepare a projected income statement for the year ended 31 May Year 5.
(ii) Calculate the projected earnings per share for the year ended 31 May Year 5.
(iii) Calculate the projected level of gearing as at 31 May Year 5.
(b) Briefly assess both of the financing schemes under consideration from the viewpoint of the existing shareholders.
(c) Calculate the level of operating profit (profit before interest and taxation) at which the earnings per share under each of the financing options will be the same.
The answer to this question can be found at the back of the book on pp. 567 – 568.
Russell Ltd
(a) (i) The projected income statements are:
| Projected income statements for the year ended 31 May Year 5 | ||
| Shares | Loan notes | |
| £000 | £000 | |
| Profit before interest and tax | 662.0 | 662.0 |
| Interest | \underline{(30.0)} | \underline{(90.0)} |
| Profit before taxation | 632.0 | 572.0 |
| Tax (25%) | \underline{(158.0)} | \underline{(143.0)} |
| Profit for the year | \underline{474.0} | \underline{429.0} |
(ii) The earnings per share (EPS) are:
| Shares | Loan notes | |
| EPS =\frac{Profit available to ordinary shareholders}{No. of ordinary shares} |
\frac{474}{(400 + 150)} \underline{£0.86} |
\frac{429}{400} \underline{£1.07} |
(iii) Gearing ratio
| Shares | Loan notes | |
| \frac{Loan capital}{Share capital + Reserves+ Loan capital} |
\frac{250}{(832.4 + 284.4 + 600.0 + 250)} \times 100\% \underline{12.7\%} |
\frac{850}{(832.4 + 257.4 + 850)} \times 100\% \underline{43.8\%} |
(See note below)
Note: The retained earnings for the year are calculated as follows:
| Shares | Loan notes | |
| £000 | £000 | |
| Profit for the year (see above) | 474.0 | 429.0 |
| Dividend proposed and paid (40% payout ratio) | \underline{(189.6)} | \underline{(171.6)} |
| Retained earnings | \underline{284.4} | \underline{257.4} |
(b) The loan notes option provides a significantly higher EPS figure than the share option. The EPS for the most recent year is £0.96 (384/400) and this lies between the two options being considered. On the basis of the EPS figures, it seems that the loan notes option is the more attractive. Pursuing the share option will lower EPS compared with the current year, and will result in a single shareholder obtaining 25 per cent of the voting share capital. As a result, this option is unlikely to be attractive. However, the gearing ratio under the loan notes option is significantly higher than under the share option. This ratio is also much higher than the current gearing ratio of the business of 23.1 per cent (250/1,082.4). The investor must balance the significant increase in financial risk with the additional returns that are generated.
(c) The level of operating profit (profit before interest and taxation) at which EPS under each option is the same will be:
Ordinary shares Ordinary shares plus loan notes
\frac{(x − 30.0)(1 − 0.25)}{(400.0 + 150.0)}=\frac{(x − 90.0)(1 − 0.25)}{400.0}
400(0.75x – 22.5) = 550(0.75x – 67.5)
300x – 9,000 = 412.5x – 37,125
112.5x = 28,125
x = \underline{250}(000)
The above figure could also have been calculated using a PBIT–EPS indifference chart as shown in the chapter.