Chapter 12 Capital Structure and Financial Ratios



Chapter 14 Financial Ratios

|SYLLABUS |

| |

|1. Assess a company’s financial position and financial risk in a scenario by calculating and assessing appropriate ratios. |

|2. Assess the impact of sources of finance on the financial position and financial risk of a company by considering the effect on |

|shareholder wealth. |

[pic]

1. Business Risk

|1.1 |Definition (Jun 12) |

| |(a) Business risk arises due to the nature of a company’s business operations, which determines the business sector into |

| |which it is classified, and to the way in which a company conducts its business operations. |

| |(b) Business risk is the variability in shareholder returns that arises as a result of business operations. |

| |(c) It can therefore be related to the way in which profit before interest and tax (PBIT or operating profit) changes as |

| |revenue or turnover changes. |

| |(d) This can be assessed from a shareholder perspective by calculating operational gearing, which essentially looks at the|

| |relative proportions of fixed operating costs to variable operating costs. |

| |(e) Operating gearing is a measure of the extent to which a firm’s operating costs are fixed rather than variable as this |

| |affects the level of business risk in the firm. Operating gearing can be measured in a number of different ways, |

| |including: |

| | |

| |1. |

| |Fixed costs |

| |or |

| | |

| | |

| |Variables costs |

| | |

| | |

| | |

| |2. |

| |Fixed costs |

| |or |

| | |

| | |

| |Total costs |

| | |

| | |

| | |

| |3. |

| |% change in EBIT (or PBIT) |

| |or |

| | |

| | |

| |% change in turnover |

| | |

| | |

| | |

| |4. |

| |Contribution |

| |or |

| | |

| | |

| |PBIT or EBIT |

| | |

| | |

| | |

| |Contribution is sales minus variable cost of sales. |

1.2 Firms with a high proportion of fixed costs in their cost structures are known as having high operating gearing.

|1.3 |Example 1 |

| |Two firms have the following cost structures: |

| | |

| |Firm A |

| |Firm B |

| | |

| | |

| |$m |

| |$m |

| | |

| |Sales |

| |5.0 |

| |5.0 |

| | |

| |Variable costs |

| |(3.0) |

| |(1.0) |

| | |

| |Fixed costs |

| |(1.0) |

| |(3.0) |

| | |

| |EBIT |

| |1.0 |

| |1.0 |

| | |

| | |

| |What is the level of operating gearing in each and what would be the impact on each of a 10% increase in sales? |

| | |

| |Solution: |

| | |

| |Operating gearing can be calculated as follows: |

| | |

| |Firm A |

| |Firm B |

| | |

| |Fixed costs/variable costs |

| |1/3 = 0.33 |

| |3/1 = 3 |

| | |

| | |

| |Firm B carries a higher operating gearing because it has higher proportion of fixed costs. |

| | |

| |Its operating earnings will therefore be more volume-sensitive: |

| | |

| |Firm A |

| |Firm A |

| |Firm B |

| |Firm B |

| | |

| | |

| |$m |

| |10% increase |

| |$m |

| |10% increase |

| | |

| |Sales |

| |5.0 |

| |5.5 |

| |5.0 |

| |5.5 |

| | |

| |Variable costs |

| |(3.0) |

| |(3.3) |

| |(1.0) |

| |(1.1) |

| | |

| |Fixed costs |

| |(1.0) |

| |(1.0) |

| |(3.0) |

| |(3.0) |

| | |

| |EBIT |

| |1 |

| |1.2 |

| |1 |

| |1.4 |

| | |

| | |

| |Firm B has enjoyed an increase in EBIT of 40% whilst Firm A has had an increase of only 20%. In the same way a decrease in|

| |sales would bring about a greater fall in B’s earning than in A’s. |

|1.4 |Example 2 |

| |If a company were to automate its production line to replace the workers currently paid an hourly wage, what would be the |

| |expected effect on its operating gearing? |

| | |

| |Solution: |

| | |

| |Swapping variable costs for fixed would increase the level of operating gearing. |

2. Financial Gearing

2.1 Financial risk

2.1.1 Financial gearing is the amount of debt finance a company uses relative to its equity finance.

|2.1.2 |Financial risk (Jun 12) |

| |The greater the level of debt, the more financial risk (of reduced dividends after the payment of debt interest) to the |

| |shareholder of the company, so the higher is their required return. |

2.1.3 Financial risk can be seen from different points of view.

(a) The company as a whole – If a company builds up debts that it cannot pay when they fall due, it will be forced into liquidation.

(b) Payables – If a company cannot pay its debts, the company will go into liquidation owing payables money that they are unlikely to recover in full. Lenders will thus want a higher interest yield to compensate them for higher financial risk and gearing.

(c) Ordinary shareholders – A company will not make any distributable profits unless it is able to earn enough profit before interest and tax to pay all its interest charges, and then tax. Ordinary shareholders will probably want a bigger expected return from their shares to compensate them for a higher financial risk.

2.2 Gearing ratios (Dec 12)

|2.2.1 |Financial Gearing |

| |Financial gearing measures the relationship between shareholders’ capital plus reserves and capital or borrowings or both.|

| |1. |

| |Equity gearing = |

| |Preference share capital + long-term debt |

| | |

| | |

| | |

| |Ordinary share capital + reserve |

| | |

| | |

| |2. |

| |Total or capital gearing = |

| |Preference share capital + long-term debt |

| | |

| | |

| | |

| |Total long-term capital |

| | |

| | |

| |3. |

| |Interest gearing = |

| |Debt interest |

| | |

| | |

| | |

| |PBIT |

| | |

| | |

| |Note: |

| |(a) Preference share capital + long-term debt (e.g. bonds, bank loans, bank overdrafts (if intended to be long term)) = |

| |prior charge capital. |

| |(b) Therefore, total long-term capital = equity + prior charge capital. |

| |(c) Since preference shares are treated as debt finance, preference dividends are treated as debt interest in this ratio. |

| |(d) For comparison purposes, the same ratio must be used consistently. |

| |(e) Capital gearing is used more than equity gearing. |

| |(f) Interest gearing is an income statement measure rather than a statement of financial position one. It considers the |

| |percentage of the operating profit absorbed by interest payments on borrowings and as a result measures the impact of |

| |gearing on profits. It is more normally seen in its inverse form as the interest cover ratio. |

2.2.2 The ratios can be calculated on either book or market values of debt and equity. There are arguments in favour of both approaches:

(a) Market values:

(i) are more relevant to the level of investment made

(ii) represent the opportunity cost of the investment made

(iii) are consistent with the way investors measure debt and equity.

(b) Book values:

(i) are not subject to sudden change due to the market factors

(ii) are readily available.

|2.2.3 |Example 3 |

| |The following excerpt has been obtained from the financial statements of ABC Co. |

| |Statement of financial position excerpt |

| | |

| |2013 |

| |2012 |

| | |

| | |

| |$000 |

| |$000 |

| | |

| |Total assets less current liabilities |

| |158 |

| |139 |

| | |

| |Non-current liabilities |

| | |

| | |

| | |

| |5% secured loan notes |

| |40 |

| |40 |

| | |

| | |

| |118 |

| |99 |

| | |

| | |

| | |

| | |

| | |

| |Ordinary share capital (50c shares) |

| |35 |

| |35 |

| | |

| |8% Preference shares ($1 shares) |

| |25 |

| |25 |

| | |

| |Share premium account |

| |17 |

| |17 |

| | |

| |Revaluation reserve |

| |10 |

| |- |

| | |

| |Income statement |

| |31 |

| |22 |

| | |

| | |

| |118 |

| |99 |

| | |

| | |

| |Income statement excerpt |

| | |

| |2013 |

| |2012 |

| | |

| | |

| |$000 |

| |$000 |

| |$000 |

| |$000 |

| | |

| |Gross profit |

| | |

| |52 |

| | |

| |45 |

| | |

| |Interest |

| |2 |

| | |

| |2 |

| | |

| | |

| |Depreciation |

| |9 |

| | |

| |9 |

| | |

| | |

| |Sundry expenses |

| |14 |

| | |

| |11 |

| | |

| | |

| | |

| | |

| |(25) |

| | |

| |(22) |

| | |

| |Net profit |

| | |

| |27 |

| | |

| |23 |

| | |

| |Taxation |

| | |

| |(10) |

| | |

| |(10) |

| | |

| |Net profit after taxation |

| | |

| |17 |

| | |

| |13 |

| | |

| |Dividends: |

| | |

| | |

| | |

| | |

| | |

| |Ordinary shares |

| |6 |

| | |

| |5 |

| | |

| | |

| |Preference shares |

| |2 |

| | |

| |2 |

| | |

| | |

| | |

| | |

| |(8) |

| | |

| |(7) |

| | |

| |Retained profit |

| | |

| |9 |

| | |

| |6 |

| | |

| | |

| |Total market values are/were as follows: |

| |2013 |

| |2012 |

| | |

| |Ordinary shares (per share) |

| |204c |

| |195c |

| | |

| |Preference shares (per share) |

| |80c |

| |102c |

| | |

| |5% loan notes (per $100 nominal value) |

| |$108 |

| |$116 |

| | |

| | |

| |Calculate: |

| | |

| |(a) Equity gearing |

| |(b) Capital gearing |

| |(c) Interest gearing |

| | |

| |For ABC Co using both statement of financial position and market values. |

| | |

| |Solution: |

| | |

| |(a) Equity gearing |

| | |

| | |

| |2013 |

| |2012 |

| | |

| |Book values |

| |[pic] |

| |= 69.9% |

| |[pic] |

| |= 87.8% |

| | |

| |Market values |

| |[pic] |

| |= 44.3% |

| |[pic] |

| |= 52.7% |

| | |

| |Note: Since preference shares are treated as debt, equity gearing could also be described as the debt/equity ratio. |

| | |

| |(b) Capital gearing |

| | |

| |2013 |

| |2012 |

| | |

| |Book values |

| |[pic] |

| |= 41.1% |

| |[pic] |

| |= 46.8% |

| | |

| |Market values |

| |[pic] |

| |= 30.7% |

| |[pic] |

| |= 34.5% |

| | |

| | |

| |(c) Interest gearing |

| | |

| |2013 |

| |2012 |

| | |

| |Interest gearing |

| |[pic] |

| |= 13.8% |

| |[pic] |

| |= 16.0% |

| | |

2.2.4 Impact of financial gearing – where two companies have the same level of variability in earnings, the company with the higher level of financial gearing will have increased variability of returns to shareholders.

|2.2.5 |Example 4 |

| |Calculate the impact on Firm C of a 10% fall in sales and comment on your results: |

| | |

| | |

| |$000 |

| | |

| |Sales |

| | |

| |10 |

| | |

| |Variable costs |

| | |

| |(2) |

| | |

| |Fixed costs |

| | |

| |(5) |

| | |

| |EBIT |

| | |

| |3 |

| | |

| |Interest |

| | |

| |(2) |

| | |

| |EAIBT |

| | |

| |1 |

| | |

| | |

| |Solution: |

| | |

| |$000 |

| |10% decrease ($000) |

| | |

| |Sales |

| |10 |

| |9 |

| | |

| |Variable costs |

| |(2) |

| |(1.8) |

| | |

| |Fixed costs |

| |(5) |

| |(5) |

| | |

| |EBIT |

| |3 |

| |2.2 |

| | |

| |Interest |

| |(2) |

| |(2) |

| | |

| |EAIBT |

| |1 |

| |0.2 |

| | |

| | |

| |The impact of a 10% decrease in sales has reduced operating earnings by (3 – 2.2)/3 = 26.67%. |

| | |

| |The increased volatility can be explained by the high operating gearing in C. |

| | |

| |However, C also has debt interest obligations. This financial gearing has the effect of amplifying the variability of |

| |returns to shareholders. The 10% drop in sales has caused the overall return to fall by (1 – 0.2)/1 = 80%. The additional |

| |53.33% variation over and above the change in operating earnings is due to the use of debt finance. |

2.2.6 Overall therefore there is a required trade-off between:

[pic]

|Multiple Choice Questions |

| |

|1. The following are extracts from the statement of profit or loss of CQB Co: |

| |

| |

|$000 |

| |

|Sales income |

|60,000 |

| |

|Cost of sales |

|50,000 |

| |

|Profit before interest and tax |

|10,000 |

| |

|Interest |

|4,000 |

| |

|Profit before tax |

|6,000 |

| |

|Tax |

|4,500 |

| |

|Profit after tax |

|1,500 |

| |

| |

|60% of the cost of sales is variable costs |

| |

|What is the operational gearing of CQB Co? |

| |

|A 5.0 times |

|B 2.0 times |

|C 0.5 times |

|D 3.0 times |

|(ACCA F9 Financial Management Pilot Paper 2014) |

| |

| |

| |

| |

|2. Which of the following would be implied by a decrease in a company’s operating gearing ratio? The company |

| |

|A is less profitable |

|B is more risky |

|C has a lower proportion of costs that are variable |

|D has profits which are less sensitive to changes in sales volume |

| |

|3. If for a given level of activity a firm’s ratio of variable costs to fixed costs were to fall and, at the same time, its ratio of |

|debt to equity were also to fall, what would be the effect on the firm’s financial and operating risk? |

| |

| |

|Financial risk |

|Operating risk |

| |

|A |

|Decreases |

|Decreases |

| |

|B |

|Increases |

|Decreases |

| |

|C |

|Decreases |

|Increases |

| |

|D |

|Increases |

|Increases |

| |

| |

|4. If a company that currently pays its workforce on a piece rate system were to automate its production line, it would expect its |

|operating gearing to |

| |

|A decrease |

|B increase |

|C remain the same |

|D increase or decrease depending on the nature of the production process |

| |

|5. Consider the following statements concerning financial gearing. |

| |

|Higher financial gearing increases the risks of: |

| |

|(i) share price volatility |

|(ii) earnings per share volatility |

|(iii) loan default |

| |

|Which of the above statements are correct? |

| |

| |

| |

|A (i) and (ii) |

|B (i) and (iii) |

|C (iii) only |

|D (i), (ii) and (iii) |

| |

|6. The following are extracts from the statement of financial position of a company: |

| |

| |

|$000 |

|$000 |

| |

|Equity |

| |

| |

| |

|Ordinary shares |

|8,000 |

| |

| |

|Reserves |

|20,000 |

|28,000 |

| |

| |

| |

| |

| |

|Non-current liabilities |

| |

| |

| |

|Bonds |

|4,000 |

| |

| |

|Bank loans |

|6,200 |

| |

| |

|Preference shares |

|2,000 |

|12,200 |

| |

| |

| |

| |

| |

|Current liabilities |

| |

| |

| |

|Overdrafts |

|1,000 |

| |

| |

|Trade payables |

|1,500 |

|2,500 |

| |

|Total equity and liabilities |

| |

|42,700 |

| |

| |

|The ordinary shares have a nominal value of 50 cents per share and are trading at $5·00 per share. The preference shares have a nominal|

|value of $1·00 per share and are trading at 80 cents per share. The bonds have a nominal value of $100 and are trading at $105 per |

|bond. |

| |

|What is the market value based gearing of the company, defined as prior charge capital/equity? |

| |

|A 15.0% |

|B 13.0% |

|C 11.8% |

|D 7.3% |

|(ACCA F9 Financial Management December 2014) |

3. Profitability and Return

3.1 Introduction

3.1.1 Profitability and return ratios are probably the most widely used. They are key to any financial manager wanting to assess performance against objectives as well ass being crucial to the investment decision.

3.1.2 An external investor will also monitor these ratios closely when deciding whether to provide the company with finance and to assess the value of the overall business.

3.2 Return on capital employed (ROCE)

3.2.1 Considered to be a key ratio, ROCE gives a measure of how efficiently a business is using the funds available. It measures how much is earned per $1 invested.

|ROCE = |Profit before interest and tax |× 100% |

| |Capital employed | |

PBIT = Operating profit

Capital employed = Share capital + Reserves + Long-term loans + Preference shares

3.3 Return on equity (ROE) or return on shareholders’ funds

3.3.1 ROE measures how much profit a company generates for its ordinary shareholders with the money they have invested in the money.

3.3.2 It is useful for comparing the profitability of a company with other firms in the same industry.

|ROE = |Profit after tax – preference dividends |× 100% |

| |Ordinary share capital + reserves | |

3.3.3 ROE is similar to ROCE except:

(a) PAT is used instead of operating profit

(b) Shareholders’ funds are used instead of capital employed.

3.4 Profit margins

3.4.1 Depending on the format of the statement of profit or loss, you may be able to calculate the gross profit margin and operating profit margin as follows:

|Gross profit margin = |Gross profit |× 100% |

| |Revenue | |

|Operating profit margin = |Operating profit |× 100% |

| |Revenue | |

3.4.2 A comparison of the changes in the two ratios can often reveal more information about cost control and the changes in operating gearing.

4. Effect on Shareholder Wealth

(Pilot, Dec 08, Jun 09, Dec 09, Jun 11, Dec 11, Jun 13, Jun 14)

4.1 Earnings per share (EPS)

4.1.1 Basic EPS should be calculated by dividing the net profit or loss for the period attributable to ordinary shareholders by the weighted average number of ordinary shares outstanding during the period.

|EPS = |Profit after tax and preference dividends |

| |Weighted average number of shares |

4.2 Price-earnings ratio (P/E)

4.2.1 P/E ratio is the ratio of a company’s current share price to the latest EPS. A high P/E ratio indicates strong market confidence in the future profit growth of the company. Conversely a low P/E ratio indicates low market confidence in the company making a profit.

4.2.2 The value of the P/E ratio reflects the market’s appraisal of the share’s future prospects. If EPS falls because of an increased burden arising from increased gearing, an increased P/E ratio will mean that the share price has not fallen as much as earnings, indicating the market views positively the projects that the increased gearing will fund.

|P/E Ratio = |Market price per share |

| |EPS |

4.3 Dividend cover

4.3.1 It is a measure of how many times the company’s earnings could pay the dividend. The higher the cover, the better the ability to maintain dividends, if profits drop.

4.3.2 This needs to be looked at in the context of how stable a company’s earnings are: a low level of dividend cover might be acceptable in a company with very stable profits, but the same level of cover in a company with volatile profits would indicate that dividends are at risk.

4.3.3 To judge the effect of increased gearing on dividend cover, you should consider changes in the dividend levels and changes in dividend cover. If earnings decrease because of an increased burden of interest payments, then:

(a) the directors may decide to make corresponding reductions in dividend to maintain levels of dividend cover.

(b) Alternatively the directors may choose to maintain dividend levels, in which case dividend cover will fall. This will indicate to shareholders an increased risk that the company will not be able to maintain the same dividend payments in future years, should earnings fall.

|Dividend cover = |EPS |

| |DPS |

4.4 Dividend yield

4.4.1 Dividend yield is the rate of return a shareholder is expecting on an investment in shares of a company. Since shareholders expect dividend yield and capital growth, dividend yield is an important indicator of a share’s performance.

4.4.2 The yield will be influenced by the dividend policy of an organization; a company which has traditionally paid high dividends will be popular with some investors and this will be reflected in its share price.

4.4.3 From investor’s standpoint, the dividend yield indicates the return that an investor earns from holding shares in a particular company, and the higher the dividend yield the better. A low dividend yield might persuade investors to dispose of shares and invest the proceeds elsewhere.

4.4.4 If the additional debt finance is expected to be used to generate good returns in the long-term, it is possible that the dividend yield might fall significantly in the short-term because of a fall in short-term dividends, but also an increase in the market price reflecting market expectations of enhanced long-term dividends.

|Dividend yield = |Gross DPS |x 100% |

| |Market price per share | |

The gross dividend is the dividend paid plus the appropriate tax credit.

4.5 Total shareholder return (TSR)

(Jun 09, Jun 14)

4.5.1 This measures the returns to the investor by taking account of dividend income and capital growth.

|TSR = |DPS + change in share price |

| |Share price at start of period |

5. Debt Holder Ratios

(Pilot, Jun 09, Jun 10, Dec 10, Jun 11, Jun 13)

5.1 Interest cover

5.1.1 Interest on loan stock (debenture stock) must be paid whether or not the company makes a profit.

5.1.2 Interest cover is a measure of the adequacy of a company’s profits relative to its interest payments on its debt:

|Interest cover = |PBIT |

| |Debt interest |

5.1.3 In general, a high level of interest cover is good but may also be interpreted as a company failing to exploit gearing opportunities to fund projects at a lower cost than from equity finance.

5.2 Interest yield

5.2.1 The interest yield is the interest or coupon rate expressed as a percentage of the market price. It is a measure of return on investment for the debt holder.

|Interest yield = |Interest rate |

| |Market value of debt |

|Multiple Choice Questions |

| |

|7. Watern plc has ordinary shares in issue with a par value of $0·50 and a price earnings ratio of 10 times. The dividend per share is |

|$0·15 and the dividend cover ratio is 2·0 times. |

| |

|What is the dividend yield of a share in the company? (Ignore taxation) |

| |

|A 20·0% |

|B 5·0% |

|C 3·0% |

|D 1·5% |

| |

|8. Kepler plc has $1 ordinary shares in issue. For the year just ended, the company generated earnings per share of 25c. The dividend |

|payout ratio for the year is 60% and the price/earnings ratio is 20 times. Ignore taxation. |

| |

|What is the gross dividend yield ratio of the company? |

| |

|A 3·0% |

|B 5·0% |

|C 8·3% |

|D 15·0% |

| |

|9. Pembroke plc has ordinary shares with a par value of $1·00 in issue. The company has a price earnings ratio of 20 times and had |

|earnings per share of $0·50 for the financial year that has just ended. The gross dividend yield is 2·0%. |

| |

|What is the dividend cover ratio of the company? |

| |

|A 0·4 times |

|B 2·5 times |

|C 25 times |

|D 50 times |

| |

|10. Starling Ltd wishes to forecast its financial performance and position for the forthcoming year. The forecast model used by the |

|company incorporates the following relationships: |

| |

|Sales : long-term capital employed |

|2 : 1 |

| |

|Debt : equity ratio |

|1 : 4 |

| |

|Sales : operating profit |

|10 : 1 |

| |

|Corporation tax : net profit before tax |

|0.2 : 1 |

| |

| |

|The sales for the forthcoming year are expected to be $6 million and the interest payments for the period are expected to be $100,000. |

| |

|What is the forecast return on ordinary shareholder’s funds (ROSF) for the period? |

| |

|A 16·7% |

|B 20·0% |

|C 25·0% |

|D 66·7%. |

| |

|11. Trinity plc wishes to forecast its financial performance and position for the forthcoming year. The forecast model used by the |

|company incorporates the following relationships: |

| |

|Sales: total capital employed 3:1 |

|Debt: total capital employed 0·4:1 |

|Sales: net profit after tax 20:1 |

|The sales for the forthcoming year are expected to be $30 million. |

| |

|What is the forecast return on ordinary shareholders’ funds for the period? |

|A 2·8% |

|B 10·7% |

|C 15·0% |

|D 25·0% |

| |

|12. TKQ Co has just paid a dividend of 21c per share and its share price is $3·50 per share. One year ago its share price was $3·10 per|

|share. |

| |

|Working to one decimal place, what is the total shareholder return over the period? |

| |

|A 17·4% |

|B 18·2% |

|C 18·9% |

|D 19·7% |

|(ACCA F9 Financial Management Pilot Paper 2014) |

| |

|13. Attis plc has reported pre-tax profits of $48 million and after-tax profits of $32 million for the year that has just ended. The |

|company expects pre-tax and after-tax profits to increase by a further 25% in the forthcoming year and then to stabilise at this |

|figure. The company has 80 million $0·50 ordinary shares in issue and the market capitalisation of the company is $320 million. The |

|dividend cover ratio of the company is held at a constant 2·5 times. |

| |

|Which one of the following is the expected rate of return from the ordinary shares? |

| |

|A 4·0% |

|B 5·0% |

|C 7·5% |

|D 40·0% |

| |

|14. Chrysotile plc has ordinary shares with a par value of $0·50 in issue. The company generated earnings per share of 45c for the |

|financial year that has just ended. The dividend cover ratio is 2·5 times and the gross dividend yield is 2% (Ignore taxation). |

| |

|What is the price/earnings ratio of the company? |

| |

|A 2·8 times |

|B 5·0 times |

|C 20·0 times |

|D 40·0 times |

| |

| |

|15. Oxon Co has ordinary shares in issue with a nominal value of $1·00. The dividend payout ratio is 20% and the gross dividend yield |

|is 4%. The earnings per share is $0·60. |

| |

|What is the price/earnings ratio of the company? |

| |

|A 25·0 times |

|B 13·8 times |

|C 5·0 times |

|D 1·8 times |

| |

|16. Meta plc has the following capital structure: |

| |

| |

|$000 |

| |

|$0.50 ordinary shares |

|4,000 |

| |

|Retained profits |

|5,000 |

| |

| |

|9,000 |

| |

| |

|The company has a return on ordinary shareholders’ funds of 10 per cent and this level of return is expected to continue after a |

|forthcoming 1-for-4 rights issue at $1·20 per share. |

| |

|What will be the earnings per share (in cent) following the rights issue? |

| |

|A 15·0 |

|B 10·0 |

|C 11·4 |

|D 22·8 |

| |

|17. The financial performance of Eboracum Co for the most recent year produced the following ratios: |

| |

|Dividend cover 5 times |

|Interest cover 6 times |

|Dividend per share $0·20 |

| |

|The company has ordinary share capital of $10m made up of $0·50 ordinary shares. The company pays tax at 20%. |

| |

|What is the net profit before interest and taxation of the company? |

| |

|A $1·2m |

|B $15·0m |

|C $28·8m |

|D $30·0m |

| |

|18. Consider the following: |

| |

|1. Altay Co has a current ratio of 1·5:1 and an operating cash cycle of 35 days and the company has decided to increase the operating |

|cash cycle by five days. |

|2. Rhodope Co has a debt/equity ratio of 45%. The company has decided to make a one-for-two scrip issue of equity shares. |

| |

|What will happen (increase/decrease) to the current ratio of Altay Co and to the debt/equity ratio of Rhodope Co if these changes are |

|made? |

| |

| |

|Current ratio of Altay Co |

|Debt/equity ratio of Rhodope Co |

| |

|A |

|Increase |

|Decrease |

| |

|B |

|Increase |

|No effect |

| |

|C |

|No effect |

|No effect |

| |

|D |

|Decrease |

|Increase |

| |

| |

|19. Tarim Co has ordinary shares in issue with a par value of $0·25. For the financial year just ended, the company had earnings per |

|share of $0·20 and a dividend cover of 2·0 times. At the year end the dividend yield was 4·0%. |

| |

|What is the price/earnings ratio of the company at the year end? |

| |

|A 2·0 times |

|B 8·0 times |

|C 12·5 times |

|D 25·0 times |

| |

| |

| |

| |

|20. The following information relates to a company: |

| |

|Year |

|0 |

|1 |

|2 |

|3 |

| |

|EPS (cents) |

|30.0 |

|31.8 |

|33.9 |

|35.7 |

| |

|DPS (cents) |

|13.0 |

|13.2 |

|13.3 |

|15.0 |

| |

|Share price at start of year ($) |

|1.95 |

|1.98 |

|2.01 |

|2.25 |

| |

| |

|Which of the following statements is correct? |

| |

|A The dividend payout ratio is greater than 40% in every year in the period |

|B Mean growth in dividends per share over the period is 4% |

|C Total shareholder return for the third year is 26% |

|D Mean growth in earnings per share over the period is 6% per year |

|(ACCA F9 Financial Management June 2015) |

| |

|21. Which of the following statements is NOT correct? |

| |

|A Return on capital employed can be defined as profit before interest and tax divided by the sum of shareholders’ funds and prior |

|charge capital |

|B Return on capital employed is the product of net profit margin and net asset turnover |

|C Dividend yield can be defined as dividend per share divided by the ex dividend share price |

|D Return on equity can be defined as profit before interest and tax divided by shareholders’ funds |

|(ACCA F9 Financial Management June 2015) |

Examination Style Questions

Question 1 – Maximization of shareholders’ wealth, rights issue effect and merits of issuing rights issue, placing and bonds

JJG Co is planning to raise $15 million of new finance for a major expansion of existing business and is considering a rights issue, a placing or an issue of bonds. The corporate objectives of JJG Co, as stated in its Annual Report, are to maximise the wealth of its shareholders and to achieve continuous growth in earnings per share. Recent financial information on JJG Co is as follows:

| |2008 |2007 |2006 |2005 |

|Turnover ($m) |28.0 |24.0 |19.1 |16.8 |

|Profit before interest and tax ($m) |9.8 |8.5 |7.5 |6.8 |

|Earnings ($m) |5.5 |4.7 |4.1 |3.6 |

|Dividends ($m) |2.2 |1.9 |1.6 |1.6 |

| | | | | |

|Ordinary shares ($m) |5.5 |5.5 |5.5 |5.5 |

|Reserves ($m) |13.7 |10.4 |7.6 |5.1 |

|8% Bonds, redeemable 2015 ($m) |20 |20 |20 |20 |

|Share price ($) |8.64 |5.74 |3.35 |2.67 |

The par value of the shares of JJG Co is $1·00 per share. The general level of inflation has averaged 4% per year in the period under consideration. The bonds of JJG Co are currently trading at their par value of $100. The following values for the business sector of JJG Co are available:

|Average return on capital employed |25% |

|Average return on shareholders’ funds |20% |

|Average interest coverage ratio |20 times |

|Average debt/equity ratio (market value analysis) |50% |

|Return predicted by the capital asset pricing model |14% |

Required:

(a) Evaluate the financial performance of JJG Co, and analyse and discuss the extent to which the company has achieved its stated corporate objectives of:

(i) maximising the wealth of its shareholders;

(ii) achieving continuous growth in earnings per share.

Note: up to 7 marks are available for financial analysis.

(12 marks)

(b) If the new finance is raised via a rights issue at $7·50 per share and the major expansion of business has not yet begun, calculate and comment on the effect of the rights issue on:

(i) the share price of JJG Co;

(ii) the earnings per share of the company; and

(iii) the debt/equity ratio.

(6 marks)

(c) Analyse and discuss the relative merits of a rights issue, a placing and an issue of bonds as ways of raising the finance for the expansion. (7 marks)

(Total 25 marks)

(ACCA F9 Financial Management June 2009 Q4)

Question 2 – WACC, interest coverage ratio, financial gearing and EPS

Droxfol Co is a listed company that plans to spend $10m on expanding its existing business. It has been suggested that the money could be raised by issuing 9% loan notes redeemable in ten years’ time. Current financial information on Droxfol Co is as follows.

Income statement information for the last year

| |$000 | |

|Profit before interest and tax |7,000 | |

|Interest |(500) | |

|Profit before tax |6,500 | |

|Tax |(1,950) | |

|Profit for the period |4,550 | |

| | | |

|Statement of financial position for the last year |$000 |$000 |

|Non-current assets | |20,000 |

|Current assets | |20,000 |

|Total assets | |40,000 |

| | | |

|Equity and liabilities | | |

|Ordinary shares, par value $1 |5,000 | |

|Retained earnings |22,500 | |

|Total equity | |27,500 |

|10% loan notes |5,000 | |

|9% preference shares, par value $1 |2,500 | |

|Total non-current liabilities | |7,500 |

|Current liabilities | |5,000 |

|Total equity and liabilities | |40,000 |

The current ex div ordinary share price is $4.50 per share. An ordinary dividend of 35 cents per share has just been paid and dividends are expected to increase by 4% per year for the foreseeable future. The current ex div preference share price is 76.2 cents. The loan notes are secured on the existing non-current assets of Droxfol Co and are redeemable at par in eight years’ time. They have a current ex interest market price of $105 per $100 loan note. Droxfol Co pays tax on profits at an annual rate of 30%.

The expansion of business is expected to increase profit before interest and tax by 12% in the first year. Droxfol Co has no overdraft.

Average sector ratios:

Financial gearing: 45% (prior charge capital divided by equity capital on a book value basis)

Interest coverage ratio: 12 times

Required:

(a) Calculate the current weighted average cost of capital of Droxfol Co. (9 marks)

(b) Discuss whether financial management theory suggests that Droxfol Co can reduce its weighted average cost of capital to a minimum level. (8 marks)

(c) Evaluate and comment on the effects, after one year, of the loan note issue and the expansion of business on the following ratios:

(i) interest coverage ratio;

(ii) financial gearing;

(iii) earnings per share.

Assume that the dividend growth rate of 4% is unchanged. (8 marks)

(Total 25 marks)

(ACCA F9 Financial Management Pilot Paper 2008 Q1)

Question 3 – WACC, interest coverage ratio, gearing and source of finance

YGV Co is a listed company selling computer software. Its profit before interest and tax has fallen from $5 million to $1 million in the last year and its current financial position is as follows:

| |$000 |$000 |

|Non-current assets | | |

|Property, plant and equipment |3,000 | |

|Intangible assets |8,500 |11,500 |

|Current assets | | |

|Inventory |4,100 | |

|Trade receivables |11,100 |15,200 |

|Total assets | |26,700 |

|Current liabilities | | |

|Trade payables |5,200 | |

|Overdraft |4,500 |9,700 |

|Equity | | |

|Ordinary shares |10,000 | |

|Reserves |7,000 |17,000 |

| | |26,700 |

YGV Co has been advised by its bank that the current overdraft limit of $4·5 million will be reduced to $500,000 in two months’ time. The finance director of YGV Co has been unable to find another bank willing to offer alternative overdraft facilities and is planning to issue bonds on the stock market in order to finance the reduction of the overdraft. The bonds would be issued at their par value of $100 per bond and would pay interest of 9% per year, payable at the end of each year. The bonds would be redeemable at a 10% premium to their par value after 10 years. The finance director hopes to raise $4 million from the bond issue.

The ordinary shares of YGV Co have a par value of $1·00 per share and a current market value of $4·10 per share. The cost of equity of YGV Co is 12% per year and the current interest rate on the overdraft is 5% per year. Taxation is at an annual rate of 30%.

Other financial information:

|Average gearing of sector (debt/equity, market value basis: |10% |

|Average interest coverage ratio of sector: |8 times |

Required:

(a) Calculate the after–tax cost of debt of the 9% bonds. (4 marks)

(b) Calculate and comment on the effect of the bond issue on the weighted average cost of capital of YGV Co, clearly stating any assumptions that you make.

(5 marks)

(c) Calculate the effect of using the bond issue to finance the reduction in the overdraft on:

(i) the interest coverage ratio;

(ii) gearing.

(4 marks)

(d) Evaluate the proposal to use the bond issue to finance the reduction in the overdraft and discuss alternative sources of finance that could be considered by YGV Co, given its current financial position. (12 marks)

(Total 25 marks)

(ACCA F9 Financial Management June 2010 Q2)

Question 4 – Dividend valuation, effect on EPS and interest cover of financing, and factors for sources of finance

GXG Co is an e-business which designs and sells computer applications (apps) for mobile phones. The company needs to raise $3,200,000 for research and development and is considering three financing options.

Option 1

GXG Co could suspend dividends for two years, and then pay dividends of 25 cents per share from the end of the third year, increasing dividends annually by 4% per year in subsequent years. Dividends in recent years have grown by 3% per year.

Option 2

GXG Co could seek a stock market listing, raising $3·2 million after issue costs of $100,000 by issuing new shares to new shareholders at a price of $2·50 per share.

Option 3

GXG Co could issue $3,200,000 of bonds paying annual interest of 6%, redeemable after ten years at par.

Recent financial information relating to GXG Co is as follows:

| |$000 |

|Operating profit |3,450 |

|Interest |200 |

|Profit before taxation |3,250 |

|Taxation |650 |

|Profit after taxation |2,600 |

|Dividends |1,600 |

| | |

|Ordinary shares (nominal value 50 cents) |5,000 |

Under options 2 and 3, the funds invested would earn a before-tax return of 18% per year.

The profit tax rate paid by the company is 20% per year.

GXG Co has a cost of equity of 9% per year, which is expected to remain constant.

Required:

(a) Using the dividend valuation model, calculate the value of GXG Co under option 1, and advise whether option 1 will be acceptable to shareholders. (6 marks)

(b) Calculate the effect on earnings per share of the proposal to raise finance by a stock market listing (option 2), and comment on the acceptability of the proposal to existing shareholders. (5 marks)

(c) Calculate the effect on earnings per share and interest cover of the proposal to raise finance by issuing new debt (option 3), and comment on your findings. (5 marks)

(d) Discuss the factors to be considered in choosing between traded bonds, new equity issued via a placing and venture capital as sources of finance. (9 marks)

(25 marks)

(ACCA F9 Financial Management June 2013 Q4)

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