Question 8.SE.3: Grenache plc operates a chain of sports shops throughout the...
Grenache plc operates a chain of sports shops throughout the UK. In recent years competition has been fierce and profits and sales have declined. The most recent financial statements of the business are as follows:
| Statement of financial position as at 30 April Year 7 | |
| £m | |
| ASSETS | |
| Non-current assets | |
| Premises | 46.3 |
| Fixtures, fittings and equipment | \underline{16.1} |
| \underline{62.4} | |
| Current assets | |
| Inventories | 52.4 |
| Trade receivables | 2.3 |
| Cash | \underline{1.2} |
| \underline{ 55.9} | |
| Total assets | \underline{118.3} |
| EQUITY AND LIABILITIES | |
| Equity | |
| £1 ordinary shares | 25.0 |
| Retained earnings | \underline{18.6} |
| \underline{43.6} | |
| Non-current liabilities | |
| 10% loan notes | \underline{25.0} |
| Current liabilities | |
| Trade payables | 48.1 |
| Tax due | \underline{1.6} |
| \underline{ 49.7} | |
| Total equity and liabilities | \underline{118.3} |
| Income statement for the year ended 30 April Year 7 | |
| £m | |
| Sales revenue | \underline{148.8} |
| Operating profit | 15.7 |
| terest payable | \underline{ (2.5 )} |
| Profit before taxation | 13.2 |
| Tax (25%) | \underline{(3.3 )} |
| Profit for the year | \underline{ 9.9} |
A dividend of £5.2 million was proposed and paid during the year.
A new chief executive was appointed during Year 7 to improve the performance of the busi-ness. She plans a ‘sand and surf’ image for the business in order to appeal to the younger market. This will require a large investment in new inventories and a complete redesign and refurbishment of the shops. The cost of implementing the plan is estimated to be £30 million.
The business is considering two possible financing options. The first option is to issue further 10 per cent loan notes at nominal value. The second option is to make a rights issue based on a 20 per cent discount on the current market value of the shares. The market capitalisation of the business is currently £187.5 million.
The future performance following the re-launch of the business is not certain. Three scenarios
have been prepared concerning the possible effects on annual operating profits (profits before
interest and taxation):
| Scenario | Change in operating profits compared to most recent year % |
| Optimistic | +40 |
| Most likely | +15 |
| Pessimistic | −25 |
The dividend per share to be proposed and paid will increase by 10 per cent during the forth-coming year if there is an increase in profit but will decrease by 20 per cent if there is a reduction in profit.
The business has a current gearing ratio that is broadly in line with its competitors.
Required:
(a) Prepare, in so far as the information allows, a projected income statement for the forthcom-ing year for each scenario assuming:
(i) a loan notes issue is made
(ii) a rights issue of shares is made. Workings should be in £m and to one decimal place.
(b) Calculate
(i) the earnings per share
(ii) the gearing ratio for the forthcoming year for each scenario, both when a loan notes issue is made and when a rights issue of shares is made.
(c) Assess the future plans and financing options being considered from the perspective of a current shareholder and state what additional information, if any, you may require to make a more considered assessment.
Grenache plc
(a) (i) Loan notes issue
| Projected income statement for the year ended 30 April Year 8 | |||
| Optimistic £m |
Most likely £m |
Pessimistic £m |
|
| Profit before interest and taxation | 22.0 | 18.1 | 11.8 |
| Interest payable (£55m × 10%) | \underline{(5.5) } | \underline{(5.5) } | \underline{(5.5) } |
| Profit before taxation | 16.5 | 12.6 | 6.3 |
| Tax (25% | \underline{(4.1) } | \underline{(3.2) } | \underline{(1.6) } |
| Profit for the year | \underline{12.4} | \underline{9.4} | \underline{4.7} |
(ii) Rights issue
| Projected income statement for the year ended 30 April Year 8 | |||
| Optimistic £m |
Most likely £m |
Pessimistic £m |
|
| Profit before interest and taxation | 22.0 | 18.1 | 11.8 |
| Interest payable (10% × £25m)) | \underline{(2.5) } | \underline{(2.5) } | \underline{(2.5) } |
| Profit before taxation | 19.5 | 15.6 | 9.3 |
| Tax (25% | \underline{(4.9) } | \underline{(3.9) } | \underline{(2.3) } |
| Profit for the year | \underline{14.6} | \underline{11.7} | \underline{7.0} |
(b) (i) Earnings per share (EPS)
Loan notes option
EPS = \frac{Profit available for ordinary shareholders}{No. of ordinary shares in issue}
| Optimistic | Most likely | Pessimistic | ||
| EPS | = | \frac{£12.4m}{25m} | \frac{£9.4m}{25m} | \frac{£4.7m}{25m} |
| = | \underline{£0.50} | \underline{£0.38} | \underline{£0.19} |
Rights option
| Optimistic | Most likely | Pessimistic | ||
| EPS | = | \frac{£14.6m}{30m} | \frac{£11.7m}{30m} | \frac{£7.0m}{30m} |
| = | \underline{£0.49} | \underline{£0.39} | \underline{£0.23} |
(ii) Gearing ratio
Loan notes option
Gearing ratio = \frac{ Loan capital}{Ordinary share capital + Reserves + Loan}
| Optimistic | Most likely | Pessimistic |
| \frac{£55m}{£(55.0 + 43.6 + 6.7)m} × 100\% | \frac{£55m}{£(55.0 + 43.6 + 3.7)m} × 100\% | \frac{£55m}{£(55.0 + 43.6 + 0.5)m} × 100\% |
| =\underline{52.2\%} | \underline{53.8\%} | \underline{55.5\%} |
Note: The retained profit for the year, which appears in the lower part of the fraction, is calculated as follows:
| Optimistic £m |
Most likely £m |
Pessimistic £m |
|
| Profit for the year | 12.4 | 9.4 | 4.7 |
| Dividends proposed and paid | \underline{( 5.7) } | \underline{( 5.7) } | \underline{(4.2) } |
| Retained profit for the year | \underline{ 6.7} | \underline{ 3.7} | \underline{ 0.5} |
Rights option
| Optimistic | Most likely | Pessimistic |
| \frac{£25m}{£(25.0 + 43.6+ 30.0 + 7.7)m} × 100\% | \frac{£25m}{£(25.0 + 43.6+ 30.0 + 4.8)m} × 100\% | \frac{£25m}{£(25.0 + 43.6+ 30.0 + 2.0)m} × 100\% |
| =\underline{23.5\%} | \underline{24.2\%} | \underline{24.9\%} |
Note: The retained profit for the year, which appears in the lower part of the fraction, is calculated as follows:
| Optimistic £m |
Most likely £m |
Pessimistic £m |
|
| Profit for the year | 14.6 | 11.7 | 7.0 |
| Dividends proposed and paid | \underline{( 6.9) } | \underline{( 6.9) } | \underline{(5.0) } |
| Retained profit for the year | \underline{ 7.7} | \underline{ 4.8} | \underline{ 2.0} |
(c) The above calculations do not reveal any major differences in EPS between the two financing options. The optimistic and most likely options are almost identical. The pes-simistic option favoursthe rights issue. The differences in the gearing ratios, however, are much more pronounced. Under each scenario the gearing ratio for the loan notes option is more than double that under the rights option. The loan notes option involves a significant increase in the level of financial risk for the business as the existing gearing ratio is 36.4 per cent (£25m/£68.6m).