Question 8.4: 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 | \underline{17.4} |
| \underline{57.6} | |
| Current assets | |
| Inventories | 22.5 |
| Trade receivables | 27.6 |
| Cash at bank | \underline{1.3} |
| \underline{51.4} | |
| Total assets | \underline{109.0} |
| EQUITY AND LIABILITIES | |
| Equity | |
| £0.25 ordinary shares | 15.0 |
| Retained earnings | \underline{46.2} |
| \underline{61.2} | |
| Non-current liabilities | |
| 12% loan notes | \underline{20.0} |
| Current liabilities | |
| Trade payables | 25.2 |
| Tax due | \underline{2.6} |
| \underline{27.8} | |
| Total equity and liabilities | \underline{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 | \underline{137.4} |
| Operating profit (profit before interest and taxation) | 23.2 |
| Interest payable | \underline{( 2.4 )} |
| Profit before taxation | 20.8 |
| Tax | \underline{( 5.2 )} |
| Profit for the year | \underline{15.6} |
A dividend of £6.0 million was paid and proposed during the year.
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:
- a rights issue of 8 million ordinary shares at a premium of £2.25 per share, or
- the issue of £20 million 10 per cent loan notes at nominal value.
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.
Which financing option should be chosen?
A useful starting point in tackling this problem is to prepare a projected income statement for the year ended 31 May Year 5 under each financing option.
| Projected income statement for the year ended 31 May Year 5 | ||
| Shares | Loan notes | |
| £m | £m | |
| Profit before interest and taxation (23.2 + 6.0) | 29.2 | 29.2 |
| Interest payable | \underline{( 2.4)} | \underline{( 4.4 )} |
| Profit before taxation | 26.8 | 24.8 |
| Tax (25%) | \underline{( 6.7)} | \underline{( 6.2 )} |
| Profit for the year | \underline{20.1} | \underline{18.6} |
Having prepared these statements, we should consider the impact of each financing option on the overall capital structure of the business. The projected capital structure under each option will be:
| Shares | Loan notes | |
| £m | £m | |
| Equity | ||
| Share capital – £0.25 ordinary shares (Note 1) | 17.0 | 15.0 |
| Share premium (Note 2) | 18.0 | |
| Retained earnings (Note 3) | \underline{58.8} | \underline{58.2} |
| \underline{93.8} | \underline{73.2} | |
| Loan capital | 20.0 | \underline{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 (£15m/£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 (dividends)) for the loan notes option.
To help us further, gearing ratios and profitability ratios may be calculated under each option.