Tobi industries wishes to undertake a project that will cost R2 500 000. The project has already been evaluated and has a positive net present value.
The decision now facing management is how to finance the project. Three alternative financial packages are under consideration:
1. Issue 1250 000 new ordinary shares at 200 cents each; or
2. Issue R2 500 000 Debenture, doe in 2020, at a fixed rate of interest of 7%; or
3. Issue 1 000 000, 15%, R2.50 preference shares.
The project is expected to generate an extra R500 000 of earnings (before interest and tax) each year. The company pays tax at 30% and follows a policy of paying a constant ordinary divided per share.
The current abridged income statement and balance sheet are as follows:
|
Abridged income statement
|
Rand
|
|
Operating profit
|
2,200,000
|
|
Interest
|
600,000
|
|
Profit before tax
|
1,600,000
|
|
Tax
|
480,000
|
|
Profit after tax
|
1,120,000
|
|
Dividend
|
320,000
|
|
Retained income
|
800,000
|
|
|
|
|
Abridged balance sheet
|
7,000,000
|
|
Non-current assets
|
6,000,000
|
|
Current assets
|
13,000,000
|
|
|
|
|
Share capital and reserves
|
8,250,000
|
|
Ordinary share capital (50 cents)
|
1,000,000
|
|
Retained income
|
7,250,000
|
|
|
|
|
Non-current liabilities:16% Debenture, due in 2017
|
3,750,000
|
|
Current liabilities
|
1,000,000
|
|
|
13,000,000
|
Required:
1. Calculate the current earnings per share (EPS)
2. Calculate the current gearing (non-current debt/equity, using book value)
3. Calculate the revised EPS and gearing using ordinary share financing
4. Calculate the revised EPS and gearing using debenture financing
5. Calculate the revised EPS and gearing using preference share financing
6. Prepare a brief report, with supporting evidence, recommending which of these three financial sources the company should use. (Average gearing level of the industry is 90%).