Financial management revision question and answer

Swaleh Ltd. has been in operation for the last eight years. The company is all equity financed with 6 million ordinary shares with a par value of Sh.5 each. The current market price per share is Sh.8.40, which is in line with the price/earnings (P/E) ratio in the industry of 6.00. The company has been consistent in paying a dividend of Sh.1.25 per share during the last five years of its operations, and indications are that the current level of operating income can be maintained in the foreseeable future. Tax has been at a rate of 30%.

The management of Swaleh Ltd. is contemplating the implementation of a new project which requires Sh.10 million. Since no internal sources of funds are available, management is to decide on two alternative sources of finance, namely:

Alternative A
To raise the Sh.10 million through a rights issue. Management is of the opinion that a price of Sh.6.25 per share would be fair.

Alternative B
To obtain the Sh.10 million through a loan. Interest is to be paid at a rate of 12% per annum on the total amount borrowed.

The project is expected to increase annual operating income Sh.5.6 million in the foreseeable future.

Irrespective of the alternative selected in financing the new project, corporation tax is expected to remain at 30%.

Required:
(i) Determine the current level of earnings per share (EPS) and the operating income of the company.

(ii) If Alternative A is selected, determine the number of shares in the rights issue and the theoretical ex-rights price.

(iii) Calculate the expected earnings per share (EPS) for each alternative, and advise Swaleh Ltd. on which alternative to accept.

(iv) “It is always better for a company to use debt finance since lower cost of debt results in higher earnings per share”.

Briefly comment on this statement.
ANSWER

Operating income is the earnings before interest and tax

It is better to finance using debt finance since it results in lower costs and hence a higher earnings per share.

(iv) The statement is true when the operating income is high. Under such circumstances EPS will increase as a result of using debt finance. However, if the level of operating income is low, debt finance will be expensive since interest has to be paid, The EPS for a geared company under such circumstances may be even negative. This may be illustrated as follows:


i.e. there is no need to use debt finance if operating income is below x. EPS would be higher if the company was all-equity financed. Beyond operating income of Sh.x debt would result in increased EPS.


Since the investment horizon is only 6 years during which DPS is expected to increase with EPS at 10%, the expected intrinsic value of a share = PV of 5

PV of all expected cash flow from holding a share:

(ii) Expected DPS at end of each year
(iii) MPS/S price at the end of year 6

Discounting rate = required return on equity = 15%

 

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