Question

Metzo Ltd is considering buying a new machine for $85000 on 1 July 2020 in order to
improve production. The general manager has approached you to advise them on
whether to buy the machine on credit or to sell some of Metzo Ltd’s equity shares in order
to finance the machine. He has provided you with the following additional information:
The estimated profit before tax and interest for 2020 and 2021 is $450000 and $420000.
Metzo Ltd can obtain a loan from ABC bank at an annual interest rate of 12% p.a. If a loan
is taken out, the interest is payable at the end of the year and the initial $85000 loan is
payable at the end of 2021. The total equity of Metzo Ltd at the end of 2019 was $750000
and it can be assumed that no other shares will be sold over the period except if it is
decided to finance the machine using equity. Please advise the manager drawing upon
theory and using the information provided (calculations of Return on equity) which
financing option to choose. It can be assumed that the tax rate is 28%.

Answer 1

Solution:

In this question the problem is related with which finance option model that Metzo Ltd. should choose for purchasing a new machine. Metzo ltd is having two finance option

1) Metzo ltd can purchase the machine by taking loan

2) Metzo ltd can purchase the Machine it by issuing equity .

Firslty we will analyse by assuming that Metzo Ltd is purchasing a machine by taking loan

When the company choose the option to buy the machine by taking loan the Metzo ltd has increased its burdern of paying interest @12% pa which deductible and so there will be tax saving by the company.The number outstanding shares will remain same i.e $75000.

When Metzo ltd Profit and loss statement and return on equity  will be as follows:

Particular	Year 2020	Year 2021
Earning before Interest and Taxes	$450000	$420000
Less : Interest on Loan	(5100)	$(10200)
Profit Before Tax	444900	$409800
Tax@28%	124572	114744
Profit After Tax	320328	295056
Number of outstanding shares	750000	750000
Return on equity = Net Income /shareholders Fund*100	$320328/750000*100 =42.71%	=$295056/750000*100=39.34%

Note :

1) Interest on loan

2020=$85000*12%*6/12=$5100

2021=$85000*12%=$10200

Secondly we will analyse by assuming that Metzo Ltd is purchasing a machine by issuing equity

When the company choose the option to buy the machine by issuing equity the Metzo ltd has will have no burdern of paying interest @12% pa which deductible and so there will be no tax saving by the company.The number outstanding shares will remain same increase because of issuing new shares.

When Metzo ltd Profit and loss statement and return on equity  will be as follows:

Particular	Year 2020	Year 2021
Earning before Interest and Taxes	$450000	$420000
Less : Interest on Loan	Nil	Nil
Profit Before Tax	450000	$420000
Tax@28%	126000	117600
Profit After Tax	324000	302400
Number of outstanding shares	=$750000+$85000=$$835000	=$750000+$85000=$835000
Return on equity = Net Income /shareholders Fund*100	$324000/$835000*100 =38.80%	=$302400/$835000=36.16%

Note:

Assumption taken that Metzo Ltd issued share of $85000(amount equal to loan).

Conclusion:

So by considering return on equity as basis of determination   

Following analysis can be drawn:

1)When loan was taken Return on equity was 42.71% and 39.34% in 2020 and 2021 respectively.

2)When Equity option  was choosen Return on equity was 38.80% and 36.16% in 2020 and 2021 respectively.

As per the analysis based on Return on equity when option of loan is choosen it gives more return to equity shareholders as compared to when equity option is chosen . So Moritz ltd must choose loan option.