Problem:
Tobi Industries wishes to undertake a project that will cost R2 500 000. The project has already been evaluated and has a positive net present value. The decision now facing management is how to finance the project. Three alternative financial "packages" are under consideration:
- Issue 1250 000 new ordinary shares at 200 cents each, or
- Issue R2 500 000 Debenture, due in 2020 at a fixed rate of interest 7%, or
- Issue 1 000 000, 15%, R2.50 preference shares.
The project is expected to generate an extra R500 000 of earnings (before interest and tax) each year. The company pays tax at 30% and follows a policy of paying a constant ordinary dividend per share.
The current abridged income statement and balance sheet are as follow:
Abridged Income statement Rand
Operating profit 2,200,000
Interest 600,000
Profit before tax 1,600,000
Tax 480,000
Profit after tax 1,120,000
Dividend 320,000
Retained Income 800,000
Abridged Balance Sheet
Non Current Assets 7,000,000
Current Assets 6,000,000
13,000,000
Share capital and Reserves 8,250,000
Ordinary Share Capital (50 cents) 1,000,000
Retained Income 7,250,000
Non- current liabilities: 16% Debenture, due in 2017 3,750,000
Current liabilities 1,000,000
13,000,000
Required to do:
Q1. Calculate the current earnings per share (EPS)
Q2. Calculate the current gearing (non-current debt/equity, using book value).
Q3. Calculate the revised EPS and gearing using ordinary share financing.
Q4. Calculate the revised EPS and gearing using debenture financing.
Q5. Calculate the revised EPS and gearing using preference share financing.
Q6. Prepare a brief report, with supporting evidence, recommending which of these three financing sources the company should use. (Average gearing level of the industry is 90%).