Question

Question One

Read the following article given below and use your knowledge to answer the questions that follow. Examples are to be provided in places where possible.

The Role of Investment into Financial Inclusion Post COVID 19 In times of crisis, access to finance is more important than ever, making investments into inclusive finance funds is even more impactful than under normal circumstances. These funds alone won’t be able to solve the problem, though. Microfinance institutions and SME banks will continue to need liquidity and their financial stability is of uttermost importance when it comes to reboot economies post COVID-19. The immediate need for liquidity for millions of small companies cannot and will not be provided by the banking sector alone, neither in developed nor in developing countries. Intelligently designed special emergency liquidity measures will be needed to support the real economy and maintain the financial sector infrastructure that has been built over the last decades.

1. Explicitly explain the next best alternative that would be available to firms to continue operations when the banking sector would not be able to provide the much needed funds to all businesses post COVID 19 pandemic.                                                             

2. Suppose that after the COVID 19 pandemic is greatly contained and that ‘life gets back to normal’ as before, OKR Ltd is deciding to use two different capital structures to expand the business. While comparing both the capital structures: In Plan I an all-equity capital structure, OKR Ltd will have 0.6 million shares outstanding while 300,000 shares would be outstanding in Plan II. Plan II is a levered plan and this would have $10,000,000.00 worth of outstanding debt. The tax rate would be 30.00% while interest rate on debt will be 10.00%.

1. What would be the break-even EBIT for OKR Ltd?                                  

2. Assuming yourself as a business director/finance manager for OKR Ltd, provide a disadvantage of using Plan II post COVID 19.                                        

3. State and explain any two scenarios whereby a firm can take tax benefits by issuing debt securities.                                                                                                

Answer 1

A)

The SME sector will require huge support from the government in the form of finance and policy in their favour to recover from the impact of COVID-19. SME sector may have to rely on the Banks for the financial support backed by the government, but the huge demand of finance would be difficult to get filled by the banks.

Supply chain financing (SCF) could be one the best alternative to the firms. SCF demands collaboration between the buyers and the seller in the supply chain. Traditionally there was competition as the buyer wanted to take extended credit, and the seller wanted quick payment. SCF works very well where the buyer has a better credit rating than the seller. SCF can cover more than one step of the supply chain. As with factoring and invoice discounting, this source of finance is only short term in nature.

Obviously, SCF could be of great help to SMEs that are supplying larger companies, or even the suppliers of larger companies, with a good credit rating. As the technological solutions required to make SCF work become more widespread and SCF grows, more and more SMEs are likely to benefit.

B)

i)

EBIT stands for Earnings before interest and Tax

EBIT = Total Revenue - COGS – Operating Expenses

Break even EBIT may be calculated as follows.

Plan 1: All equity (0.6 million shares)

Plan 2: Debt amount -10,000,000

              Equity - 0.3 million shares

Consider EBIT as x

Equation will be as follows

{x(1-Tax Rate)/ Shares Outstanding }={(x-(Debt*Rate of Interest)(1- Tax Rate))/Shares Outstanding}

{x(1-0.3)/0.6}={(x-(10,000,000*0.1)(1-0.3))/0.3}

Solving the equation gives x as 2,000,000 which is the value of EBIT.

ii)

Plan 2 involves 100% of the debts amount. The firm may be at disadvantage if its opts for the plan 2 in the post COVID-19 period. The condition of the economy is very bad in the current scenario. Taking such huge debt in expectation that the post epidemic period would help them repay the loan is like digging once own grave. The period will bring longer credit cycles and greater bad debts affecting a great deal to the company’s profitability and cashflow requirements. An expectation of business at the similar level to that of pre COVID period is also scanty. The period would be marked by decrease in turnover and greater difficulty in the survival of the firms.

Therefore taking a huge debt fill only increase the cyclical liability and pressure on the firms profitability and cash flow.

iii)

Advantages of issuing debt securities may be as follows

· The interest paid by the company against debt may be deductible against tax whereas the dividend payable to the shareholder is not is not tax deductible.

· The interest paid to the security holder may be capitalized if used for it and later tax benefit in the form of depreciation may claimed, this is not possible in case of shareholding.