Question 2.SE.5: Semplice Ltd manufactures catering equipment for restaurants...
Semplice Ltd manufactures catering equipment for restaurants and hotels. The statement of financial position of the business as at 31 May Year 4 is as follows:
| Statement of financial position as at 31 May Year 4 | |
| £m | |
| ASSETS Non-current assets |
|
| Premises | 40.2 |
| Machinery and equipment | 17.4 |
| 57.6 | |
| Current assets | |
| Inventories | 22.5 |
| Trade receivables | 27.6 |
| Cash at bank | 1.3 |
| 51.4 | |
| Total assets | 109.0 |
| EQUITY AND LIABILITIES Equity |
|
| £0.25 ordinary shares | 15.0 |
| Retained earnings | 46.2 |
| 61.2 | |
| Non-current liabilities | |
| 12% loan notes | 20.0 |
| Current liabilities | |
| Trade payables | 25.2 |
| Tax due | 2.6 |
| 27.8 | |
| Total equity and liabilities | 109.0 |
An abridged income statement for the year ended 31 May Year 4 is as follows:
| Income statement for the year ended 31 May Year 4 | |
| £m | |
| Sales revenue | 137.4 |
| Operating profit (profit before interest and taxation) | 23.2 |
| Interest payable | (2.4) |
| Profit before taxation | 20.8 |
| Tax | (5.2) |
| Profit for the year | 15.6 |
The board of directors of Semplice Ltd has decided to invest £20 million in new machinery and equipment to meet an expected increase in sales for the business’s products. The expansion in production facilities is expected to result in an increase of £6 million in annual operating profit (profit before interest and taxation).
- To finance the proposed investment, the board of directors is considering either
(i) a rights issue of eight million ordinary shares at a premium of £2.25 per share, or
(ii) the issue of £20 million 10 per cent loan notes at nominal value. - A dividend of £6.0 million was proposed and paid during the year.
- The directors wish to increase the dividend per share by 10 per cent in the forthcoming year irrespective of the financing method chosen.
Assume a tax rate of 25 per cent.
Required:
(a) Prepare a projected income statement (in abbreviated form) for the year to 31 May Year 5 under each financing option.
(b) Show the projected long-term capital structure of the business under each financing option as at 31 May Year 5.
(c) Using the information in your answer to (a) and (b) above, compute the earnings per share and degree of financial gearing for each financing option.
(d) Briefly evaluate the two financing options under consideration.
Semplice Ltd
(a) Projected income statement for the year ended 31 May Year 5
| Shares £m |
Loan notes £m |
|
| Operating profit (23.2 + 6.0) | 29.2 | 29.2 |
| Interest payable | (2.4) | (4.4) |
| Profit before taxation | 26.8 | 24.8 |
| Tax (25%) | (6.7) | (6.2) |
| Profit for the year | 20.1 | 18.6 |
(b) The projected capital structure under each option will be:
| Shares £m |
Loan notes £m |
|
| Equity | ||
| Share capital – £0.25 ordinary shares | 17.0 | 15.0 |
| (Note 1) | ||
| Share premium (Note 2) | 18.0 | |
| Retained earnings (Note 3) | 58.8 | 58.2 |
| 93.8 | 73.2 | |
| Loan capital | 20.0 | 40.0 |
Notes:
- The number of shares in issue (25p shares) for the share issue option is 68 million (£17m/£0.25) and for the loan note option is 60 million (£15 m/£0.25).
- The share premium account represents the amount received from the issue of shares that is above the nominal value of the shares. The amount is calculated as follows: 8 million × £2.25 = £18 million.
- The retained earnings will be £58.8 (46.2 + 20.1 – 7.5 (dividends)) for the shares option and £58.2 (46.2 + 18.6 – 6.6 (dividend)) for the loan notes option.
(c)
| Shares | Loan notes | |
| Earnings per share | ||
| Share issue EPS \frac{£20.1 m}{68 m} | 29.6 p | |
| Loan notes EPS \frac{£18.6 m}{60 m} | 31.0 p | |
| Degree of financial gearing | ||
| Share issue degree of financial gearing = \frac{£29.2 m}{(£29.2 m – £2.4 m)} | 1.1 | |
| Loan note issue degree of financial gearing = \frac{£29.2 m}{(£29.2 m – £4.4 m)} | 1.2 |
(d) The loan notes option provides ordinary shareholders with better returns. We can see the earnings per share is almost 5 per cent higher than under the share option. However, the loan notes option also produces a higher level of financial gearing and, therefore, a higher level of financial risk. Nevertheless, the operating profit comfortably exceeds the interest charges. There is not a substantial difference in the degree of financial gearing between the two options. In both cases, returns to shareholders are not very sensitive to changes in operating profit. Managers may, therefore, decide that the increase in earnings per share is worth the increase in financial gearing.