QUESTION 5: The Board of Directors of Sycal Berhad decided to expand its present
ID: 2807692 • Letter: Q
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QUESTION 5: The Board of Directors of Sycal Berhad decided to expand its present production capacity with an investment of $20 million. This decision is based on their forecast of a demand for its products. The Board has assigned the task of choosing the method of financing the $20 million expansion to the Finance Committee The finance committee is considering the following financing alternatives Option 1: Issuance of $20 million bonds carrying a coupon rate of 12 % Option 2: Issuance of new common stocks worth $20 million at an issue price of S1.60 per share Option 3: By issuing $10 million bonds with a coupon rate of 1 190 and $10 million new shares at an issue price of S1.60 per share The Balance Sheet of Sycal Berhad as at June 30, 2016 is as follows Share capital of $1 each Retained profits Long-term loans @ 10 % Current liabilities $ 000 16,000Fixed assets 7,000Inventory 10,000Debtors 7,000 Bank S 000 26,000 6,000 6,000 2,000 Sycal Berhad's present earnings before interest and tax (EBIT) are $7.2 million. The increase in EBIT as the result of the expansion is estimated to be S3.8 million. . The present quoted price of Sycal Berhad shares is S1.94 and its price-earnings (P/E) ratio is 10 Depending on the financing alternative chosen, the P/E ratio will change as follows Expected New P/E Ratio Option (1) Option (2) Option (3) 8.0 11.0 10.0 Assume that the tax rate applicable to the company is 45 % a) For each of the 3 financing alternatives calculate the earnings per share and the expected (17 marks) market price if the expansion is carried out b) Which financing alternative should be chosen? Explain why that despite a higher EPS the (3 marks) all-debt financing is not preferred?Explanation / Answer
.a CALCULATION OF EARNING PER SHARE AND EXPECTED MARKET PRICE
OPTION 1: Issuance of $20 million bonds carrying a coupon rate of 12%
Present EBIT (Earning Before Interest and Taxes) =$7.2 million
Increase in EBIT=$3.8 million
Total EBIT after expansion=(7.2+3.8)=$11 million
Interest expenses:
10% interest on long term loan of $10 million=$1million
12% interest on $20 million bond issued=$2.4 million
Total interest expenses=(1+2.4)=$3.4 million
Earning after interest (Before tax)=(11-3.4)=$7.6 million
Tax at the rate of 45%=(0.45*7.6)=$3.42 million
Net Earning after tax=(7.6-3.42)=$4.18 million
Number of shares outstanding=16 million
Earning per share=(4.18/16)=$0.26
New P/E Ratio=8
Expected market price=8*0.26=$2.09
OPTION 2: Issuance of new common stock worth $ 20 million at an issue price of $1.60 per share
Number of shares issued=(20/1.6)=12.5 million
Total number of shares after new issue=(16+12.5)=28.5 million
Total EBIT after expansion=(7.2+3.8)=$11 million
Interest expenses:
10% interest on long term loan of $10 million=$1million
Earning after interest (Before tax)=(11-1)=$10 million
Tax at the rate of 45%=(0.45*10)=$4.5 million
Net Earning after tax=(10-4.5)=$5.5 million
Number of shares outstanding=28.5 million
Earning per share=(5.5/28.5)=$0.19
New P/E Ratio=11
Expected market price=11*0.19=$2.12
OPTION 3: Issuance of $10 million bonds carrying a coupon rate of 11% and $10 million new shares at issue price of $1.6 per share
Number of new shares issued=(10/1.6)=6.25 million
Total EBIT after expansion=(7.2+3.8)=$11 million
Interest expenses:
10% interest on long term loan of $10 million=$1million
11% interest on $10 million bond issued=$1.1 million
Total interest expenses=(1+1.1)=$2.1 million
Earning after interest (Before tax)=(11-2.1)=$8.9 million
Tax at the rate of 45%=(0.45*8.9)=$4.005 million
Net Earning after tax=(8.9-4.005)=$4.895 million
Number of shares outstanding=(16+6.25) million=22.25 million
Earning per share=(4.895/22.25)=$0.22
New P/E Ratio=10
Expected market price=10*0.22=$2.2
.b
Expected
Option
EPS
Market price
1
$0.26
$2.09
2
$0.19
$2.12
3
$0.22
$2.20
Option 3 should be preferred
Despite high EPS option 1 should not be selected . This option increases the risk of the firm. Consequently required rate of return by the shareholders increases.
The shareholders wealth decreases.
The maximum shareholders wealth will be in option 3 . hence this option should be selected
Expected
Option
EPS
Market price
1
$0.26
$2.09
2
$0.19
$2.12
3
$0.22
$2.20
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