Question 10.4: Two companies, X Ltd and Y Ltd, commence business with the f...
Two companies, X Ltd and Y Ltd, commence business with the following long-term capital structures:
| X Ltd | Y Ltd | |
| $ | $ | |
| Paid-up ordinary capital | 100,000 | 200,000 |
| 10% loan | 200,000 | 100,000 |
| 300,000 | 300,000 |
In the first year of operations they both make an operating profit (profit before interest and taxation) of $50,000. In this case, the tax rate is assumed to be 30% of the profit before tax but after interest. X Ltd would be considered highly geared, as it has a high proportion of borrowed funds in its long-term capital structure. Y Ltd has lower levels of gearing. The available to the shareholders of each company in the first year of operation will be:
| X Ltd | Y Ltd | |
| $ | $ | |
| Operating profit | 50,000 | 50,000 |
| Interest expense | (20,000) | (10,000) |
| Taxation (say 30%) | 30,000 | 40,000 |
| Profit available to ordinary shareholders | (9,000) | (12,000) |
| 21,000 | 28,000 |
The return on shareholders’ funds (ROSF) for each company will be:
| X Ltd | Y Ltd |
| $ | $ |
| \frac{21,000 \times 100}{100,000} = 21% | \frac{28,000 \times 100}{200,000} = 14% |
We can see that X Ltd, the more highly geared company, has generated a better return on shareholders’ funds than Y Ltd. This is in spite of the fact that the return on capital employed is identical for both business (i.e. ($50,000/300,000) × 100 = 16.7%).
Note that at the $50,000 level of operating profit, the shareholders’ of both X Ltd and Y Ltd benefit from gearing. Were the two business totally reliant on equity financing, the profit for the year (after taxation profit) would be $35,000 (i.e. $50,000 less 30% taxation), giving an ROSF of 11.7% (i.e. $35,000/$300,000). Both business generate higher RPSFs than this as a result of financial gearing.