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Assignment - Debt and Equity Financing - Prepare a report for presentation to the board of directors which will include the following:

(i) forecast income statements and balance sheet for the year ending 31 December 2019 if the rights issue was used to finance the investment.

(ii) forecast income statements and balance sheet forthe year ending 31 December 2019 if the bond was used to finance the investment.

(iii) a discussion of whether the company is likely to achieve its financial objectives in the year ending 31 December 2019.

(iv) a justified recommendation as to the most appropriate source of finance from the above two options.

Solution - Debt and Equity Financing

Introduction

Selection of the most suitable sources of financing is a critical decision as different sources of financing have different costs and risk levels. Debt financing and Equity financing are two major sources of financing for a business, but both sources have different risk and costs and vary regarding costs and risks according to the situation. In the given case, Flash plc, a manufacturer of solar panels, supplies industrial sized equipment across the UK, particularly to offices and factories. As the market is competitive, Flash plc wants to buy worth £6,000,000 more efficient panels for producing electricity from lower levels of sunlight to reduce the production costs of the equipment. The company has to make a decision, whether it should adopt of irredeemable 7% Bond financing or Right Shares at £1.50 per share financing for the arrangement of buying cost of the panels.

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(i) Right Issue

Flash plc

 

Income Statement

 

For the year ended 31 December

2018

Forecasted 2019

 


£000

£000

 

Revenue

£60,240.00

£65,059.20

 

Less: Costs and expenses

£45,000.00

£47,250.00

 

Less: Depreciation expense


£2,000.00

 

Operating profit

£15,240.00

£15,809.20

 

Less: Finance costs

£530.00

£530.00

 

Profit before tax

£14,710.00

£15,279.20

 

Less: Tax

£2,942.00

£3,055.84

 

Profit after tax

£11,768.00

£12,223.36

 

Less: Dividends

£4,707.00

£4,889.34

 

Retained earnings

£7,061.00

£7,334.02

 

Flash plc

Balance Sheet

As At 31 December

2018

Forecasted 2019

ASSETS

£000

£000

Non-current assets



Land and building

£28,850.00

£28,850.00

Panels


£6,000.00

Less: Accumulated Depreciation-Panels


-£2,000.00

Total Non-Current Assets

£28,850.00

£32,850.00

Current assets



Inventories

£9,020.00

£9,020.00

Trade receivables

£7,400.00

£7,992.00

Cash

£396.00

£9,719.20

Total Current Assets

£16,816.00

£24,731.20

Total Assets

£45,666.00

£59,581.20

EQUITY AND LIABILITIES



Equity



Share capital (£1 per share)

£24,700.00

£28,700.00

Retained earnings

£7,617.00

£14,951.02

Security Premium


£2,000.00

Total Equity

£32,317.00

£45,651.02

Non-current liabilities



Total Non-Current Liabilities



Current liabilities



Trade payables

£5,700.00

£5,985.00

Other payables (tax and dividends)

£7,649.00

£7,945.18

Total Current Liabilities

£13,349.00

£13,930.18

Total Liabilities

£13,349.00

£13,930.18

Total Equity and Liabilities

£45,666.00

£59,581.20







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(ii) Bond Issue

Flash plc

Income Statement

For the year ended 31 December

2018

Forecasted 2019


£000

£000

Revenue

£60,240.00

£65,059.20

Less: Costs and expenses

£45,000.00

£47,250.00

Less: Depreciation expense


£2,000.00

Operating profit

£15,240.00

£15,809.20

Less: Finance costs

£530.00

£950.00

Profit before tax

£14,710.00

£14,859.20

Less: Tax

£2,942.00

£2,971.84

Profit after tax

£11,768.00

£11,887.36

Less: Dividends

£4,707.00

£4,754.94

Retained earnings

£7,061.00

£7,132.42

 

Flash plc

Balance Sheet

As At 31 December

2018

Forecasted 2019

ASSETS

£000

£000

Non-current assets



Land and buildng

£28,850.00

£28,850.00

Panels


£6,000.00

Less: Accumulated Depreciation-Panels


-£2,000.00

Total Non-Current Assets

£28,850.00

£32,850.00

Current assets



Inventories

£9,020.00

£9,020.00

Trade receivables

£7,400.00

£7,992.00

Cash

£396.00

£9,299.20

Total Current Assets

£16,816.00

£26,311.20

Total Assets

£45,666.00

£59,161.20

EQUITY AND LIABILITIES



Equity



Share capital (£1 per share)

£24,700.00

£24,700.00

Retained earnings

£7,617.00

£14,749.42

Total Equity

£32,317.00

£39,449.42

Non-current liabilities



7% Bond


£6,000.00

Total Non-Current Liabilities


£6,000.00

Current liabilities



Trade payables

£5,700.00

£5,985.00

Other payables (tax and dividends)

£7,649.00

£7,726.78

Total Current Liabilities

£13,349.00

£13,711.78

Total Liabilities

£13,349.00

£19,711.78

Total Equity and Liabilities

£45,666.00

£59,161.20

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(iii) Discussion

The right share issue has the following criteria figures that should be achieved in order to fit for the financial arraignment:

 

2018

Forecasted 2019

ROCE

47.16%

34.63%

Increased Profit After Tax (PAT) (in Thousands)

£7,061.00

£7,334.02

Increased EPS (in Pence)

47.64

42.59

Current Ratio (at least1.45 times )

1.26

1.92

The criterion of a minimum return on capital employed 35% is not achieved by the issue of right shares as the ROCE is 34.63%. The increased profitability criterion is achieved by this option. The criterion of the current ratio is achieved by the company as minimum current ratio is 1.45, whereas the current ratio in 2019 would be 1.92 times. However, this option reduces EPS in 2019 as the EPS would be 42.59 pence in 2019 as compared to EPS 47.64 pence in 2018. Therefore, this option is not most suitable for the company.

The bond issue has the following criteria figures that should be achieved in order to fit for the financial arraignment:


2018

Forecasted 2019

ROCE

47.16%

34.78%

Increased Profit After Tax (PAT) (in Thousands)

£7,061.00

£7,132.42

Increased EPS (in Pence)

47.64

48.13

Current Ratio (at least1.45 times)

1.26

1.92

The minimum criterion of ROCE 35% is not met by this option as the ROCE is 34.78% in 2019. The increased profitability under this option indicates its suitability for the selection process. The achievement of the current ratio at least 1.45 times due to the expected current ratio of 1.92 times in 2019 indicates a beneficial option for the company. The increased EPS from 47.64 pence in 2018 to 48.13 pence in 2019 indicates improvement in the return to the shareholders with the increased dividend per share. Therefore, the company should select the issue of bond for the arrangement of the financing for the acquisition of the panels for the purpose.

(iv) Recommendation

The arrangement of financing for panels by the issue of right shares is not much suitable to the company as compared to the financing arrangement by the issue of bond. The reasons for more suitability of issue of the bond are a higher increase in the earnings per share (EPS), higher current ratio, and higher net profitability. However, the issue of the bond has a lower return on capital employed as compared to issue right shares. The return on capital employed is not much important for the company. Therefore, it is highly recommended that the company should select issue bond for the financial arrangement of acquisition of panels.

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