Question 14.5: Yor plc is a fast-growing, hi-tech business. Its income stat...
Yor plc is a fast-growing, hi-tech business. Its income statement for the year ended 30 September 2010 and its balance sheet as at 30 September 2010 are shown below. The company has the opportunity to take on a major project that will significantly improve its profitability in the forthcoming year and for the foreseeable future. The cost of the project is £10m, which will result in large increases in sales, which will increase profit before interest and tax by £4m per annum. The directors of Yor plc have two alternative options of financing the project: the issue of £10m of 4% debentures at par, or a rights issue of 4m ordinary shares at a premium of £1.50 per share (after expenses).
Regardless of how the new project is financed, the directors will recommend a 10% increase in the dividend for 2010/2011. You may assume that the effective corporation tax rate is the same for 2010/2011 as for 2009/2010.
| Yor plc Income statement for the year ended 30 September 2010 |
|
| £m | |
| PBIT | 11.6 |
| Finance costs | \underline{(1.2)} |
| Profit before tax | 10.4 |
| Income tax expense | \underline{(2.6)} |
| Profit for the year | 7.8 |
| Retained earnings 1 October 2009 | \underline{5.8} |
| 13.6 | |
| Dividends | \underline{(3.0)} |
| Retained earnings 30 September 2010 | \underline{10.6} |
| Yor plc Balance sheet as at 30 September 2010 |
|
| £m | |
| Non-current assets | |
| Tangible | \underline{28.8} |
| Current assets | |
| Inventories | 11.2 |
| Trade and other receivables | 13.8 |
| Cash and cash equivalents | \underline{0.7} |
| Total current assets | \underline{25.7} |
| Total assets | \underline{54.5} |
| Current liabilities | |
| Trade and other payables | 9.7 |
| Dividends payable | 1.6 |
| Income tax payable | \underline{2.6} |
| Total current liabilities | \underline{13.9} |
| Non-current liabilities | |
| 6% loan | \underline{20.0} |
| Total liabilities | \underline{33.9} |
| Net assets | \underline{20.6} |
| Equity | |
| Share capital (£1 ordinary shares) | 10.0 |
| Retained earnings | \underline{10.6} |
| Total equity | \underline{20.6} |
The directors of Yor plc would like to see your estimated income statement for 2010 / 2011,
and a summary of the equity and debt at 30 September 2011, assuming:
(i) the new project is financed by an issue of the debentures
(ii) the new project is financed by the issue of new ordinary shares
To assist in clarification of the figures, you should show your calculations of:
(iii) eps for 2009 / 2010
(iv) eps for 2010 / 2011, reflecting both methods of financing the new project
(v) dividend per share for 2009 / 2010
(vi) dividend per share for 2010 / 2011, reflecting both methods of financing the new
project
Use the information you have provided in (i) and (ii) above to:
(vii) calculate Yor plc’s gearing, reflecting both methods of financing the new project, and
compare with its gearing at 30 September 2010
(viii) summarise the results for 2010 / 2011, recommend which method of financing Yor plc
should adopt, and explain the implications of both on its financial structure.
(i)
| Yor plc Income statement for the year ended 30 September 2011 |
||
| using debentures | using shares | |
| £m | £m | |
| PBIT | 15.6 | 15.6 |
| Finance costs | \underline{ (1.6)} | \underline{(1.2)} |
| Profit before tax | 14.0 | 14.4 |
| Income tax expense | \underline{ (3.5)} | \underline{ (3.6)} |
| Profit for the year | 10.5 | 10.8 |
| Retained earnings 1 October 2010 | 10.6 | 10.6 |
| 21.1 | 21.4 | |
| Dividends | \underline{(3.3)} | \underline{(4.6)} |
| Retained earnings 30 September 2011 | \underline{17.8} | \underline{16.8} |
(ii)
| Yor plc
Equity and debt as at 30 September 2011 |
||
| using debentures | using shares | |
| £m | £m | |
| Share capital (£1 ordinary shares) | 10.0 | 14.0 |
| Share premium account (4m × £1.50) | 6.0 | |
| Retained earnings | \underline{17.8} | \underline{16.8} |
| \underline{27.8} | \underline{36.8} | |
| Loans | \underline{30.0} | \underline{20.0} |
(iii)
earnings per share 2010 =\frac{ profit available for ordinary shareholders}{number of ordinary shares in issue} = \frac{ £7.8 m}{10 m} =78 p(iv)
using debentures
using shares
earnings per share 2011 =\frac{ £10.8 m}{14 m} = 77 p(v)
dividend per share 2010 = \frac{total dividends paid to ordinary shareholders}{number of ordinary shares in issue} = \frac{ £3.0 m}{10 m} =30 p
(vi)
using debentures
dividend per share 2011 = \frac{ £3.3 m}{10 m} = 33 p
using shares
dividend per share 2011 = \frac{ £4.6 m}{14 m} = 33 p
(vii)
gearing = \frac{ long-term debt}{equity + long-term debt}
| using debentures | using shares | |
| 2010 | 2011 | 2011 |
| \frac{£20.0 m}{£20.6 m + £20.0 m} = 49.3\% | \frac{£30.0 m}{£27.8 m + £30.0 m} = 51.9\% | \frac{£20.0 m}{£36.8 m + £20.0 m} = 35.2\% |
(viii)
Summary of results
| Figures in £m | |||
| using debentures | using shares | ||
| 2010 | 2011 | 2011 | |
| Profit for the year | 7.8 | 10.5 | 10.8 |
| Dividends | \underline{(3.0)} | \underline{(3.3)} | \underline{(4.6)} |
| Retained earnings for year | \underline{4.8} | \underline{7.2} | \underline{6.2} |
The use of debentures to finance the new project will increase the 2010/2011 profit for the year after tax,
available for dividends, by £2.7m or 34.6%, whereas if shares were used the increase would be £3.0m or 38.5%. Earnings per share will be increased to £1.05 (+27p) and decreased to 77p (−1p) respectively.
However, retained earnings would be increased by £2.4m (50%) and £1.4m (29.2%) respectively. The difference is because the gain from the lower interest cost in using shares is more than off set by the increase in dividends.
Dividend per share will be increased from 30p to 33p per share regardless of which method of financing is used.
Gearing at 30 September 2010 was 49.3%. If debentures are used to finance the new project then gearing will increase to 51.9%, but if shares are used to finance the new project then gearing will decrease to 35.2%. This represents a higher financial risk for the company with regard to its commitments to making a high level of interest payments. The company is therefore vulnerable to a downturn in business and also the possibility of its loans being called in and possible liquidation of the company.