COMPANY STRUCTURE.

Q1) A companys Balance Sheet shows the following capital structure;Ms 40 25 20

Ordinary shares Retained earnings Debentures (redeemable 2015 - 10% coupon rate)

If the companys Profit Before Interest &Tax is 15m, and Corporation Tax is 25%, calculate the Companys Weighted Average Cost of Capital. Ms 15 (2) 13 (3.25) 9.75

PBIT Less Interest

Less Corporation Tax Net Profit for the Year

Return on Owners Equity = 9.75M or

9.75 100 40 25 1

9.75 100 65 1

= 15%

Cost of Capital;cost in money terms after tax % 15 weighted money cost % 7.065

weighting Ordinary Shares (40m @ 1) Retained Earnings (25m) Debentures (10%) (debt=20m) 47.1%

29.4%

15

4.410

23.5% 100%

7.5

1.7625 13.2375

Companys Weighted Average Cost of Capital = 13.24%

COMPANY GEARING.

Shares ms Debt (10%) ms

A 100 -

B 50 50

C 67 33

Ms Revenue Cost of goods sold 100 (60)

Ms 100 (60)

Ms 100 (60)

Gross profit Admin. expenses

40 (10)

40 (10)

40 (10)

PBIT Interest

30 (0)

30 (5)

30 (3.3)

PBT Tax (25%)

30 (7.5)

25 (6.25)

26.7 (6.675)

Net profit for the year

22.5

18.75

20.025

Earnings per share;-

0.225

0.375

0.2988

Q2) A companys accounts show the following details;millions Issued shares (1 par value) Retained earnings Debentures (redemption 2020) 10% coupon rate Bank loan (due 2015) 8% fixed interest rate If the companys PBIT is 30 million and Corporation Tax is 25%;a) Calculate the companys Weighted Average Cost of Capital. b) Restructure the companys capital base, fully justifying the structure you have proposed and state any assumptions you have made. ms 30 50. 35. 20. 10.

a) Profit before Interest and Tax Less Interest;Debentures (10%) Debt. Loan (8%)

= 2 = 0.8 (2.8)

Profit Before Tax Less Tax (25%) Net Profit

27.2 (6.8) 20.4

Return

on Owners Equity

= =

20.4m. 24.0%

OR

20.4 50 35

100 1

20.4 100 85 1

ms Shares Retained earnings Debentures (10%) Bank loan (8%) 50 35 20 10 115

The

(%) cost after tax% = monetary cost 43.5 30.4 17.4 8.7 100 24.0 24.0 7.5 6.0 10.44 7.30 1.31 0.52 19.57%

companys Weighted Average Cost of Capital = 19.57%

b)

Owners Equity Shares = 50m Ret. Earnings = 35m 85m

Debt. Debentures = 20m Bank Loan = 10m 30m

Total Capital Employed = (85+30) = 115m.

Gearing Ratio = (2 Equity) + (1 Debt) = Capital Structure. 2 : 1 Gearing Ratio;- (77m) + (38m) = 115m.

Therefore Owners Equity should be reduced by 8m to 77 m and debt increased by 8m to 38m, ie Reduce Retained Earnings to 27m and increase the loan to 18m, (assuming a loan of 8m can be obtained, it can be used to pay a Bonus Dividend funded against the Retained Earnings).

Restructured Company; ms Profit before Interest and Tax Less Interest;Debentures (10%) Debt. Loan (8%) 30

= 2 = 1.44 (3.44)

Profit Before Tax Less Tax (25%) Net Profit

26.56 (6.64) 19.92

Return on

Owners Equity

= =

19.92m. 25.87%

OR

19.92 50 27

100 1

19.92 100 77 1

ms 50 27 20 18 115

(%) cost after tax% = monetary cost 43.5 23.5 17.4 15.6 100 25.87 25.87 7.5 6.0 11.25 6.08 1.30 0.94 19.57%

Shares Retained earnings Debentures (10%) Bank loan (8%)

The

companys Weighted Average Cost of Capital = 19.57%

By increasing the bank loan the company can take good advantage of cheap money, ie. the cost of capital for the company remains the same at 19.57% however the earnings on Owners Equity has increased from 24.0% to 25.87% therefore earning more for the owners on ever of their wealth and the shareholders have also received a one off bonus dividend of 8m covered by the Retained Earnings which is now at its optimum ratio. The above assumes that the company can borrow the extra 8m loan at 8% fixed interest and has sufficient cash flow to fund the extra 640,000 interest. However the companys tax relief on this extra loan reduces the Corporation Tax burden from 6.8m to 6.64m per year, a reduction of 140,000 per annum.