Pesca Industrial

problem

Calculations

Current EPS:

£5.778mn

10mn =57.78p Current gearing (debt:equity using book values):

£12m+ £6mn

£22.02mn = 817. %

Impact on EPS and gearing of the three different sources of finance

This question gives no indication as to the impact on earnings of the extra £10 million of investment. Thus it will be assumed that it will generate the same return on investment as at present.

Operating profit: £11.17mn

Capital employed: £34.02mn= £32.8% Thus the extra £10 million of capital will generate extra operating profits of:

£10mn × 0.328 = £3.28mn (i) Ordinary share financing

It is assumed that the new shares will be issued at a 10% discount on the current share price of 350p: 315p.

Thus, the number of new shares issued will be:

£10mn/315p = 3 175 00 approx.

Also, it is assumed that the company will maintain its current dividend per share payout of: £3.467mn 10mn =34.67p share/ £mn Operating profit 11.17 + 3.28 = 14.45 Interest (2.28) Pre-tax profit 12.17 Tax at 35% (4.26) Earnings 7.91 Dividends (10mn + 3.175mn) ×34.67p = (4.57) Retained earnings 3.34

Chapter 20 Capital structure in practice

Revised EPS: £ . . 7 91 13175 60 mn mn = p Revised gearing: £12mn + £6mn £22.02mn + £10mn + £3.34mn =50.9% (ii) Preference share financing

£mn Operating profit 14.45 Interest (2.28) Pre-tax profit 12.17 Tax at 35% (4.26) Earnings 7.91 Preference dividends (1.40) Earnings available for shareholders 6.51

Dividends (3.467) Retained earnings 3.043 Revised EPS: £6.51mn 10mn =65.1p Revised gearing: £12mn + £6mn + £10mn £22.02mn + £3.043mn =1117. % (iii) Loan stock financing

£mn Operating profit 14.45 Interest 2.28 + 1.2 = (3.48) Pre-tax profit 10.97 Tax at 35% (3.84) Earnings 7.13 Dividend (3.467) Retained earnings 3.663 Revised EPS: £7.13mn 10mn = 71 3. p Revised gearing: £12mn + £6mn + £10mn £22.02mn + £3.663mn =109%

Report to the Directors of Latost plc

Dear Sirs

We have analysed the probable impact of the three proposed financing packages of the company’s EPS and gearing levels. The results are shown below:

EPS Gearing

Current situation 57.78p 81.7% Equity financing 60p 50.9% Preference financing 65.1p 111.7% Loan stock financing 71.3p 109%

All three financing packages will result in an increase in EPS. Financing via preference shares or loan stock will increase the level of gearing, while financing with equity will reduce the gearing.

The decision as to which financing package should be chosen is not clear-cut. However, the analysis would appear to suggest that loan stock financing is a better alter- native to preference share financing as the loan stock alternative provides a significantly higher EPS and a marginally lower level of gearing.

This then narrows the choice between equity financing and loan stock financing. It is here that the directors must judge the trade-off that their shareholders will find accept- able between risk and return.

Equity financing results in a small increase in EPS from 57.78p to 60p, but does provide a substantial reduction in gearing (and hence, a reduction in the riskiness of ordinary shares) from 81.7% to 50.9%.

In contrast, loan stock financing results in a substantial increase in EPS from 57.78p to 71.3p, but it also increases the level of gearing from an already high 81.7% up to 109%.

We would suggest that the final choice be made after investigating the gearing levels of Latost’s competitors. If the competitors have gearing levels of around 100%, then it would be reasonable to assume that such a high level of gearing is acceptable and, on balance, the loan stock option should be selected.

However, if Latost’s competitors generally have a much lower level of gearing, then the equity financing alternative may represent the more acceptable course of action. Yours faithfully

B.E.R. Tie Accountants

problem

(a) ‘Business risk’ arises out of the risky nature of the company’s business, which mani- fests itself in the variability of the company’s earnings stream (before interest and tax). Quite simply, some companies have very stable earnings streams because of the steady, low-risk nature of their businesses. A supermarket company might be one such example. In contrast, some other companies have highly volatile earnings, again because of the very variable high-risk nature of their businesses. A small oil-exploration company might serve as a suitable example of a company with a high degree of business risk.

Portfolio theory shows that risks can be divided up into systematic risk and unsys- tematic risk. Systematic risk is that part of total risk that cannot be diversified away, while unsystematic risk is the risk that can be diversified away. Therefore business risk is partially systematic and partially unsystematic.

The systematic element of business risk is largely (but not completely) out of the control of the individual company management. The unsystematic element of business risk arises out of factors which are specific to the individual company and are directly under the control of management.

The two main determinants of a company’s exposure to systematic business risk would be the sensitivity of the company’s revenues to the level of economic activity in the economy (and its sensitivity to macroeconomic events in general), and its proportion of fixed-to-variable ‘operating’ costs, i.e. the costs incurred in generating those revenues – principally material, labour and energy costs. The greater its revenue sensitivity and the greater its proportion of fixed costs, the greater its exposure to systematic business risk.

Such factors as revenue sensitivity and fixed-to-variable operating costs are largely out of management’s control, and arise out of the nature of the market and the produc- tion technology. Thus a carpet manufacturing business can do very little about the highly revenue-sensitive nature of the business (people buy new carpets when the

economy booms and not otherwise). Nor can the manufacturer do much about the high proportion of fixed costs involved in carpet production technology.

However, it should be noted that these factors are not entirely out of management’s control. For example, the carpet manufacturer may try to lock his customers into long-term deals to bring greater stability to the revenues. Similarly they may try to sub- contract out as much of the manufacturing process as they can, on short-term contracts, to keep as many of their costs variable as possible.

The unsystematic aspects of business risk arise from such factors as the skill of the top management team, the training of the workforce, the state of labour relations and the ability of the marketing department. Obviously, such factors are largely under the direct control of the management.

(b) An investor with a well diversified share portfolio will have eliminated all unsystem- atic risk. Therefore such an investor is only going to be interested in the systematic element of business risk which, together with financial risk, goes to make up the beta value of the shares.

(c) (1) Degree of operating gearing (DOG)

DOG at a given level of turnover is:

Turnover Variables costs Profit before interest and

–

tax At the start of the current financial year:

DOG 3381 – 2193 462 2.57

= =

Assume that variable costs comprise wages and salaries, raw materials and direct selling expenses. (In reality these are not all likely to vary directly with turnover.)

One interpretation of a 2.57 DOG may be that a 1% change in sales will lead to a 2.57% change in profit before interest and tax (in the same direction).

At the end of the financial year, the expected profit and loss account, assuming no price changes except those stated, is:

(£000s) (£000s)

Turnover (15% increase) 3 888

Operating expenses:

Wages and salaries (1 220 × 0.80 × 1.15) 1 122 Raw materials (15% increase) 1 004 Direct selling prices (15% increase) 115 General administration (no increase) 346 Other fixed costs (£85 000 increase) 465

3 052

Profit before interest and tax 836

Therefore expected DOG at the end of the year is: 3888 2241

836 –

=1.97 The degree of operating gearing is expected to fall.

If a high percentage of a company’s total costs are fixed, that company will have a high degree of operating gearing. If other factors are held constant the higher the operating gearing the higher will be the business risk of a company. In this case other factors have

not been held constant; the unit variable cost of wages and salaries and also the level of

fixed costs are expected to change. The overall result is a lower DOG at the sales level of £3 888 000.

Financial gearing

As an accounting-based analysis of the company is being undertaken, an accounting-based measure of financial gearing will be used:

Balance sheet value of debt Shareholders' funds At the start of the year financial gearing is 570

1510= 37.7%

At the end of the year profit before interest and tax has been estimated to be £836 000.

(£000s)

Profit before interest and tax 836

Interest (207)

Profit before tax 629

Tax (252)

Profit available to ordinary shareholders 377 Estimated dividend (189)

Retained earnings 188

Estimated financial gearing 570 820 1510 188

+

+ = 81.8%.

The expected financial gearing more than doubles by the end of the year. The higher the level of financial gearing, the higher the financial risk placed on the ordinary shareholders.

(c) (2) (i) If turnover increases by 15%, the expected profit available to ordinary shareholders is £377 000. There are 3 200 000 issued ordinary shares resulting in an expected earnings per share of 11.78 pence.

The earnings per share at the start of the year is £227 000

3 200 000 =7.09 pence per share.

Because of the financial and operating gearing effects, earnings per share are expected to increase by 66%.

(c) (2) (ii) If turnover falls by 10%

(£000s) (£000s)

Turnover 3 043

Operating expenses:

Wages and salaries (1 220 × 0.90 × 0.80) 878 Raw materials (10% fall) 786 Direct selling expenses (10% fall) 90 General administration (no change) 346 Other fixed costs (£85 000 increase) 465

2 565 Profit before interest and tax 478

Interest (207)

Profit before tax 271

Tax (108)

The estimated earnings per share is £163 000

3 200 000= 5.09 pence. This is 28% lower than the current earnings per share.

The changes in the operating and financial gearing have increased the risks for the shareholders.