Question

LG Ltd needs to raise $500,000 to finance the acquisition of a new tour bus. It approached an investment bank that proposed the following alternatives:

The issue of 8%, cumulative preference shares for $500,000 with a fixed redemption date 5 year from the date of issue; or

The issue of 10%, non-cumulative, preference shares of $500,000, redeemable at the option of the issuer

The preference share issue is planned for 2019. The accountant prepared an abridged projected statement of financial position for LG Ltd as at 30 June 2019, based on the company’s master budget. The projected statement of financial position excludes the effects of the proposed preference share issue or the investment .

Projected Statement of Financial Position as at 30 June 2019
Assets	Amount ($)	Liabilities and Equity	Amount ($)
Assets	2,500,000	Liabilities	1,500,000
		Equity	1,000,000
	2,500,000		2,500,000

Additional information (excluding the effects of the proposed preference share issue or investment ):

LG Ltd estimates profit before interest and tax (EBIT) for the year ended 30 June 2019 as $420,000. This estimate is based on this year’s performance, adjusted for the effects of the additional investment.

Interest expense in relation to a bank loan included in ‘Liabilities’ amounts to $100,000.

The bank loan includes a debt covenant which specifies a maximum leverage ratio (total liabilities to total assets) of 60%.

The company has investigated alternative sources of funding and found that most lenders require it to have maintained an interest coverage ratio (EBIT to Interest expense) graeter than 3.0.

Management receives a bonus of 2% of profit before tax, provided the return on investment (EBIT to Total assets) exceeds 12%.

1. Calculate the LG Ltd’s leverage ratio at 30 June 2019 based on the projected statement of financial position.

2. Prepare a journal entry to record the annual dividend payable on the 8% cumulative and the 10% non-cumulative preference shares.

3. Using the projected figures and estimates provided, calculate LG Ltd’s leverage ratio and interest coverage ratio assuming the company issues 8% cumulative and the 10% non-cumulative preference shares.

4. Compare LG Ltd’s profit before tax for each financing alternative.

5. Drawing on the agency theory, explain which financing arrangement would be preferred by management. Where relevant, refer to your analysis of financial statement implications

Answer 1

1.Leverage Ratio

A. Total Liabilities to Total Assets Rattio

= Total Liabilities /Total Assets

=1500000/2500000

=60%

B. Interest Coverage Ratio

=EBIT/Interest Expenses

=$420000/$100000

=4.2

2. Journal Entries on Issue payment of Dividend

1. On Commulative Prefence share

Cumulative preferred stock simply means that the dividends on the stock are cumulative. If a business does not declare a dividend in one year, then the dividend will continue to accumulate on the cumulative stock.

If company dont delare the dividend

Retain Earning a/c Dr $40,000

To Dividend in Arrear $40,000

If dividend Decared and Paid

a. Retain Earning a/c Dr $40,000

To Dividend on 8% Commulative Prefence share Payable $40,000

b.Dividend on 8% Commulative Prefence share Payable $40,000

To Bank a/c $40,000

2. On Commulative Prefence share

Non-cumulative preference shares are those type of preference shares, which have right to get fixed rate of dividend out of the profits of current year only. They do not carry the right to receive arrears of dividend. If a company fails to pay dividend in a particular year then that need not to be paid out of future profits

If Company pay Dividend

a. Retain Earning a/c Dr $50,000   

To Dividend on 10% Non Commulative Prefence share Payable $50,000

If company dont pay dividnd

a. NO ENTRY IN BOOKS

3.

A. Leverage Ratio

Prefence share is part of Equity on the issue of both share Total Asstes of company will increase by $500,000

=$1500,000/($2500,000+$500,000)

=50%

B. Interest Coverage ratio

=4.2

4.

On issue of cumulative Prefence share

EBIT $420,000

less:-interest $100,000

earning after interest $320000

less dividend $40000

$280000

iN CASE OF Non cumulative pre share and declaration of dividned

EBIT $420,000

less:-interest $100,000

earning after interest $320000

less dividend $50000

$270000

If company dont declare dividend than EBT WILL BE $320000