Question

- Questo QUESTION SIX (a) The Directors of a company to be formed are considering three alternatives for raising K50 million to establish the business. These are given in the three scenarios below Scenario 1 Ordinary K10 par shares for K50 million Scenario 2 Ordinary K10 par shares for 8% Preferred K10 par shares for K40 million K10 million Scenario 3 Ordinary K10 par shares for 8% Preferred K10 par shares for 8% Bonds for K31 million K4 million K15 million The directors expect a 10% return on investment after tax but before servicing the K50 million. They are also desirous of transferring from profits to retained earnings K3 million each year. (0) Assuming a tax rate of 35%, prepare a statement showing the profit position and dividend available for ordinary shareholders for each of the financing alternatives, (9 marks) (ii) Make a recommendation as to the method of fund raising you favor, giving reasons for your choice as well as reasons for not favoring the other methods. In general, what factors would influence your choice of long term source of finance (10 marks) b) A company buys on terms of 1/10, net 30, but it has not been taking discounts and has actually been paying in 60 days. Accounts payable have risen to K250,000 and suppliers are now threatening to stop supplies unless the company begins making prompt payments. To become current on its account, the company can borrow a 1 year note from the bank at a rate of 15% discount interest, with an 18% for any compensating balance. Determine what action the company should take by calculating: 0 The cost of none free trade credit, and (ii) The cost of the bank loan. (6 marks) (25 marks)

Answer 1

a]		Scenario 1	Scenario 2	Scenario 3
	NOPAT = 50,000,000*10% =	5000000	5000000	5000000
	Less: After tax interest on bonds	0	0	780000
	Less: Preferred dividends	0	800000	320000
	Profit available to ordinary shareholders	5000000	4200000	3900000
	Less: Transfer to retained earnings	3000000	3000000	3000000
	Dividend available to ordinary shareholders	2000000	1200000	900000
b]	Number of ordinary shares outstanding	5000000	4000000	3100000
	EPS [Profit available to ordinary shareholders/Number of ordinary shares]	1.00	1.05	1.26
	Financial leverage:
	EBIT = 5000000/(1-35%)	7692308	7692308	7692308
	Interest			1200000
	Preferred dividends/(1-35%)	0	1230769	492308
	DFL = EBIT/[EBIT-Interest+Preferred dividends/(1-t)] =	1.00	1.19	1.28
	The preferred choice would be Scenario 3, as it yields the highest EPS.
	The higher EPS is due to the higher financial leverage in Scenario 3. Higher financial leverage
	means use of higher proportions of fixed cost sources of funds [Debt and Preferred stock] in the
	Capital Structure.
	Scenarios 1 & 2, have lower expected EPS and hence are not chosen.
	Fixed cost sources of funds would be preferred when the basic earning power, that is EBIT/Total assets]
	is more than the cost of debt and the return on total equity is more than the cost of preferred stock.
	Here, the basic earning poser = 10%/(1-35%) = 15.38%, which is more than the cost of debt of 8% and
	the return on equity is more than the cost of preferred stock of 8%. The return on total equity is 12.5%
	for Scenario 2 [5/40] and 12.06 for Scenario 3.
	Further, the change in P/E ratio should also be considered as, with higher levels of financial leverage,
	the P/E ratio is likely to go down.
b]	Cost of trade credit for 50 days = (1/99) =	1.01%
i)	Effective annual cost of trade credit = (1+1/99)^(365/50)-1 =	7.61%
	Amount to be borrowed = 250000/(0.82/0.85) =	259146
ii)	Interest payable = 259146*15% =	38872
	Effective rate of interest on the bank loan:
	Amount repayable = 259146*85% =	220274
	Amount received	250000
	Effective interest rate = 1-220274/250000 =	11.89%
	As the cost of trade credit is lower, the company can take the
	trade credit.