Question

Q1

On 1 July 20X1 Newplans Ltd raised $5,000,000 by issuing preference shares with a cumulative 10% dividend. The amount of the dividend is $500,000 per annum. The payment of the dividend is not tax deductible.

The preference share issue was very complicated and involved the exercise of professional judgement to determine how they should be classified. The accountant prepared draft financial statements and sent them to the chief executive officer (CEO) for approval. The accountant classified the preference shares as liabilities, with a carrying amount of $5,000,000, in the draft financial statements. The following information is obtained from the draft 20X2 financial statements:

$

Profit before interest and tax

900,000

Interest expense (includes preference dividend paid)

600,000

Profit before tax

300,000

Total Liabilities (includes preference shares)

12,500,000

Total Equity

7,500,000

Total Assets

20,000,000

Newplans Ltd’s liabilities include a long term debt contract that includes the following covenants:

• maintain leverage (liabilities/total assets) below 60%
• interest coverage (Profit before interest and tax/interest expense) must be at least 3.0
The CEO’s incentive-based remuneration is subject to a performance hurdle of 5% return on investment, calculated as profit before tax divided by total assets.

Required

Label your responses a) b) and c)

a) Calculate the following ratios for Newplans Ltd using the draft financial statements with the preference shares classified as liabilities :

i) leverage (total liabilities/ total assets)

ii) interest coverage (Profit before interest and tax/interest expense)

iii) return on investment (profit before tax / total assets at the end of the period)

b) Calculate the following items for Newplans Ltd if, alternatively, the preference shares were classified as equity :

i) Interest expense

ii) total equity

iii) leverage (total liabilities/ total assets)

iv) interest coverage (Profit before interest and tax/interest expense)

v) return on investment (profit before tax / total assets at the end of the period)

c) According to agency theory, how would the management of NewPlans Ltd prefer to classify the preference shares? Refer to the facts in this scenario and use calculations to support your argument.

Answer 1

To solve this question just input those variables which are to be used in logistic regression, as the question talks about using two variables only that is total loans and leases to total assets & total expenses/ total assets, so we will not input total cap/assets as an input variable in our excel, here we go

As one can see, we have taken only two variables , total exp/assets and total lns & leases/ assets in calculation, follwing steps have been followed to construct the above table

1. Assume logit= b0+ b1* independent variable1+ b2* independent variable 2 , take values of b0=0.1, b1=0.1, b2=0.1, note that these values of b0, b1 and b2 are just taken for calculation, one could assume any values here for bo , b1 and b2

2. Calculate exponential of logit in the next column by using exp (value in previous column)

3. Calculate probability by using formula, probability= exp (logit)/ { 1+ exp(logit)} in the next column

4. In next column, calculate log likelihood by using formula : financial condition value (i.e. 1 or 0) * LN( probability calculated in previous column) + (1- financial condition value)* LN( 1- probability calculated in previous column)

5. take the total of the column values of log likelihood

6. use solver function in excel to change this total by putting max value of 0 and changing the variable cells containing assumed values of b0, b1 and b2 , by clicking on solve, you will get actual values of b0, b1 and b2

which comes out to be b0=-14.72, b1=89.83, b2= 8.37

therefore you will get logit as

-14.72+ 89.83* Total exp/assets+8.37*Total lns & lsses/ assets

With values given in the question as total exp/ assets= 0.11 and total loans & leases/ assets= 0.6 , we get

logit as -14.72+ 89.83* 0.11+ 8.37*0.6= 0.1833

exp (logit) = 1.20

Probability= 0.546

Loglikelihood= 1*LN(0.546)+0*LN(1-0.546)= LN(0.546)= -0.605