Question

Manny Co is a listed company that plans to spend K10m on expanding its existing business. It has been suggested that the money could be raised by issuing 9% loan notes redeemable in ten years’ time. Current financial information on Manny Co is as follows.

Income statement information for the last year

                                                                                                                        K000

Profit before interest and tax                                                                             7,000

Interest                                                                                                             (500)

Profit before tax                                                                                                6,500

Tax                                                                                                                  (1,950)

Profit for the period                                                                                           4,550

Balance sheet for the last year                                                  K000                K000

Non-current assets                                                                                           20,000

Current assets                                                                                                  20,000

Total assets                                                                                                     40,000

Equity and liabilities

Ordinary shares, par value K1                                                   5,000

Retained earnings                                                                     22,500

Total equity                                                                                                      27,500

10% loan notes                                                                                     5,000

9% preference shares, par value K1                                          2,500

Total non-current liabilities                                                                                7,500

Current liabilities                                                                                               5,000

Total equity and liabilities                                                                                  40,000

The current ex div ordinary share price is K4.50 per share. An ordinary dividend of 35 cents per share has just been paid and dividends are expected to increase by 4% per year for the foreseeable future. The current ex div preference share price is 76.2 cents. The loan notes are secured on the existing non-current assets of Manny Co and are redeemable at par in eight years’ time. They have a current ex interest market price of K105 per K100 loan note. Manny Co pays tax on profits at an annual rate of 30%.

The expansion of business is expected to increase profit before interest and tax by 12% in the first year. Manny Co has no overdraft.

Average sector ratios:

Financial gearing: 45% (prior charge capital divided by equity capital on a book value basis)

Interest coverage ratio: 12 times

Required:

(a) Calculate the current weighted average cost of capital of Manny Co.

(b) Discuss whether financial management theory suggests that Manny Co can reduce its weighted average cost of capital to a minimum level.

(c) Evaluate and comment on the effects, after one year, of the loan note issue and the expansion of business on the following ratios:

(i) Interest coverage ratio;

(ii) Financial gearing;

(iii) Earnings per share.

Assume that the dividend growth rate of 4% is unchanged.

Answer 1

Answer : -

1) Weighted average cost of capital

Formula : - Weight of debt * Net cost of debt + Weight of Equity * Cost of equity + Weight of preference share * cost of preference shares

Loan Notes = 5000000*105% = 5250000

Equity = 5000000*4.5 = 22500000

Preference Shares = 2500000*76.2% = 1905000

Total = 2,96,55,000

Cost of Debt (Net of taxes) = 10*(1-.30) = 7%

Tax rate identified as = 1950/6500 = 30%

Cost of preference shares = 9%

Cost of Equity = Net profit/ Equity Value

= 4550000 / (5000000+22500000) = 16.545%

Total cost = 5000000*7% + 22500000*16.545% + 1905000*9% = 4244177

WACC = Total cost/ Total amount

4244177 / 29655000 = 14.31 %

2) Financial Management theory explain that company should take the funding decision keeping in mind the cost of capital to avail that fund. By looking the post tax cost of different class i.e debentures, Equity, Preference shares it can be dervied that company can reduce its WACC if they induce more funds from debentures because it is the cheapest source of finance.

As the degree of Debenture and preference share will increase, Cost of capital will be decrease gradually.

3) EBIT for the next year = 7000000*1.12 = 78,40,000

Interest = 500000 (Existing Int) + 900000 (New Loan Int.) = 1400000

Interest coverage ratio = 7840000/1400000 = 5.60 Tiimes

Capital gearing ratio = Common shareholder Equity / Fixed cost bearing funds

= 22500000 / (10000000 + 5000000 + 2500000 )

22500000/ 17500000 = 1.285714

Earning per Share

Earning = 7840000

Interest = 1400000

Net = 6440000

Net profit = 6440000*.70 = 4508000

EPS = Net profit/ No of shares

4508000/5000000 = 0.90/Share

Thanks,

Best Regards