Question 6.SE.6: Telford Engineers plc, a medium-sized manufacturer of automo...
Telford Engineers plc, a medium-sized manufacturer of automobile components, has decided to modernise its factory by introducing a number of robots. These will cost £20 million and will reduce operating costs by £6 million a year for their estimated useful life of 10 years starting next year (Year 10). To finance this scheme, the business can raise £20 million either by issuing:
1 20 million ordinary shares at 100p; or
2 loan notes at 7 per cent interest a year with capital repayments of £3 million a year commen-cing at the end of Year 11.
Telford Engineers’ summarised financial statements appear below:
| Summary of statements of financial position at 31 December | ||||
| Year 6 £m |
Year 7 £m |
Year 8 £m |
Year 9 £m |
|
| ASSETS | ||||
| Non-current assets | 48 | 51 | 65 | 64 |
| Current assets | \underline{55} | \underline{67} | \underline{57} | \underline{55} |
| Total assets | \underline{103} | \underline{118} | \underline{122} | \underline{119} |
| EQUITY AND LIABILITIES | ||||
| Equity | \underline{48} | \underline{61} | \underline{61} | \underline{63} |
| Non-current liabilities | \underline{30} | \underline{30} | \underline{30} | \underline{30} |
| Current liabilities | ||||
| Trade payables | 20 | 27 | 25 | 18 |
| Short-term borrowings | \underline{5} | \underline{-} | \underline{6} | \underline{8} |
| \underline{25} | \underline{27} | \underline{31} | \underline{26} | |
| Total equity and liabilities | \underline{103} | \underline{118} | \underline{122} | \underline{119} |
| Number of issued 25p shares | 80m | 80m | 80m | 80m |
| Share price | 150p | 200p | 100p | 145p |
Note that the short-term borrowings consisted entirely of bank overdrafts.
| Summary of income statements for years ended 31 December | ||||
| Year 6 £m |
Year 7 £m |
Year 8 £m |
Year 9 £m |
|
| Sales revenue | \underline{152} | \underline{170} | \underline{110} | \underline{145} |
| Operating profit | 28 | 40 | 7 | 15 |
| Interest payable | \underline{ (4 )} | \underline{ (3 )} | \underline{ (4) } | \underline{(5) } |
| Profit before taxation | 24 | 37 | 3 | 10 |
| Tax | \underline{ (12 )} | \underline{ (16 )} | \underline{ (0) } | \underline{(4) } |
| Profit for the year | \underline{12} | \underline{21} | \underline{6} | \underline{3} |
| Dividends paid during each year | 6 | 8 | 3 | 4 |
You should assume that the tax rate for Year 10 is 30 per cent, that sales revenue and operating profit will be unchanged except for the £6 million cost saving arising from the introduction of the robots, and that Telford Engineers will pay the same dividend per share in Year 10 as in Year 9.
Required:
(a) Prepare, for each financing arrangement, Telford Engineers’ projected income statement for the year ending 31 December Year 10 and a statement of its share capital, reserves and loans on that date.
(b) Calculate Telford’s projected earnings per share for Year 10 for both schemes.
(c) Which scheme would you advise the business to adopt? You should give your reasons and state what additional information you would require.
Telford Engineers plc
(a) Projected income statements for the year ending 31 December Year 10:
| Loan notes £m |
Shares £m |
|
| Operating profit | 21.00 | 21.00 |
| Interest payable | \underline{7.80} ((20 × 14%) + £5m) | \underline{ (5.00 )} |
| Profit before taxation | 13.20 | 16.00 |
| Tax (30%) | \underline{(3.96 )} | \underline{ (4.80 )} |
| Profit for the year | \underline{9.24} | \underline{11.20} |
| Dividends payable | 4.00 | 5.00 |
Statements of share capital, reserves and loans:
| Loan notes £m |
Shares £m |
|
| Equity | ||
| Share capital 25p shares | 20.00 | 25.00 (20m + (20m × 0.25)) |
| Share premium | – | 15.00 (20 × (1.00 − 0.25)) |
| Reserves^{*} | \underline{48.24} | \underline{49.20} |
| 68.24 | 89.20 | |
| Non-current liabilities | \underline{50.00} | \underline{30.00} |
| \underline{118.24} | \underline{119.20} | |
* The reserves figures are the Year 9 reserves plus the Year 10 (after taxation) profit less dividend paid. The Year 9 figure for share capital and reserves was 63, of which 20 (that is, 80 × 0.25) was share capital, leaving 43 as reserves. Add to that the retained profit for Year 10 (that is, 5.24 (loan) or 6.20 (shares)).
b) The projected earnings per share are:
| Loan notes (9.24/80) | 11.55p | |
| Shares (11.20/100) | 11.20p |
(c) The loan notes option will raise the gearing ratio and lower the interest cover of the business. This should not provide any real problems for the business as long as profits reach the expected level for Year 9 and remain at that level. However, there is an increased financial risk as a result of higher gearing and shareholders must carefully consider the adequacy of the additional returns to compensate for this higher risk. This appears to be a particular problem since profit levels seem to have been variable over recent years. The figures above suggest only a marginal increase in EPS compared with the equity alternative at the expected level of profit for Year 9.
The share alternative will have the effect of reducing the gearing ratio and is less risky. However, there may be a danger of dilution of control by existing shareholders under this alternative and it may, therefore, prove unacceptable to them. An issue of equity shares may, however, provide greater opportunity for flexibility in financing future projects. Information concerning current loan repayment terms and the attitude of shareholders and existing lenders towards the alternative financing methods would be useful.