Question

In: Accounting

The following three companies have asset financing structures which are considered to be aggressive, average and...

The following three companies have asset financing structures which are considered to be aggressive, average and defensive strategists:

  Statement of Financial Position as at 31st December, 2019

Aggressive Ltd

Average Ltd

Defensive Ltd

GHȼ000

GHȼ 000

GHȼ 000

Noncurrent assets

175,000

125,000

100,000

Current assets

75,000

125,000

150,000

Total assets

250,000

250,000

250,000

Equity(100,000,000 @ Gh1)

50,000

50,000

50,000

25% Debenture

50,000

75,000

150,000

Current liabilities (average cost 3% pa)

Bank overdraft

150,000

125,000

50,000

Total equity and liabilities

250,000

250,000

250,000

Notes:

  • The companies finance some aspects of business operations with bank overdraft at the interest of 15% per annum.
  • Each of the three companies recorded Net Profit before Interest and Taxes (EBIT) of GHȼ80,000,000.
  • Corporate tax is 25%

Required

  1. Describe three characteristics of the following working capital strategists listed below:
  1. Aggressive working capital strategy
  2. Average working strategy
  3. Moderate working strategy

Calculate the EPS for the three working capital financing strategists for the year ended December 31, 2019.

Solutions

Expert Solution

Characteristics of Working capital strategy:

Aggresive Strategy:

1. There is a high risk of bankruptcy due to extremely tight liquidity position being maintained.

2. Since the interest cost is minimized in this approach, higher profitability is obtained.

3. Liquidity is low due to greater dependability on short-term funds even for a part of long-term assets. It does not keep idle funds and therefore saves interest cost on them.

Moderate/Defensive Strategy:

1. There is a very low risk of bankruptcy as a higher level of liquidity is maintained in the business in this approach.

2. Under normal circumstances, profitability is less in this strategy because of too much idle and costly funds. Higher rate and bigger magnitude of interest cost reduce the profitability.

3. Liquidity is high, because of heavy usage of long-term funds. It can take advantage of sudden opportunities.

Average Strategy:

1. The risk is balanced here. The firm will bow down to bankruptcy only in an extremely bad situation.

2. Because of cut to cut management, a balance is achieved between interest cost and loss of profitability. Moderate profitability is maintained here. It is greater than conservative and lesser than aggressive.

3. Liquidity is balanced i.e. neither high nor low. It attempts to strike a balance between liquidity and cost of idle funds.

Calculation of EPS:

Particulars Aggressive Ltd Average Ltd Defensive Ltd
Net Profit before Interest and Tax (EBIT)                  80,000,000.00                  80,000,000.00                  80,000,000.00
Less: Bank Interest @ 15%                  22,500,000.00                  18,750,000.00                    7,500,000.00
Less: Interest on Debentures @ 25%                  12,500,000.00                  18,750,000.00                  37,500,000.00
Earning Before Taxes                  45,000,000.00                  42,500,000.00                  35,000,000.00
Less: Tax @ 25%                  11,250,000.00                  10,625,000.00                    8,750,000.00
Net Earning available for shareholders                  33,750,000.00                  31,875,000.00                  26,250,000.00
Equity Shares             100,000,000.00             100,000,000.00             100,000,000.00
Earning Per share                                  0.34                                  0.32                                  0.26

For understading:

You can see EPS in Aggresive method is higher than Defensive method. and EPS in Average method is balanced.


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