The following are extracts from the statement of profit or loss of CQB Co:
| $’000 | |
|---|---|
| Sales income | 60,000 |
| Cost of sales | 50,000 |
| Profit before interest and tax | 10,000 |
| Interest | 4,000 |
| Profit before tax | 6,000 |
| Tax | 4,500 |
| Profit after tax | 1,500 |
60% of the cost of sales is variables costs.
What is the operational gearing of CQB Co?
A. 5·0 times
B. 2·0 times
C. 0·5 times
D. 3·0 times
GWW Co is a listed company which is seen as a potential target for acquisition by financial analysts. The value of the company has therefore been a matter of public debate in recent weeks and the following financial information is available:
| year | 2009 | 2010 | 2011 | 2012 |
| profit after tax ($m) | 8.5 | 8.9 | 9.7 | 10.1 |
| total dividends ($m) | 5.0 | 5.2 | 5.6 | 6.0 |
Statement of financial position information for 2012
| $m | $m | |
| non-current assets | 91.0 | |
| current assets | ||
| inventory | 3.8 | |
| trade receivables | 4.5 | 8.3 |
| ----- | ----- | |
| total assets | 99.3 | |
| ----- | ||
| equity finance | ||
| ordinary shares | 20.0 | |
| reserves | 47.2 | 67.2 |
| ----- | ||
| non-current liabilities | ||
| 8% bonds | 25.0 | |
| current liabilities | 7.1 | |
| ----- | ||
| total liabilities | 99.3 | |
| ----- |
The shares of GWW Co have a nominal (par) value of 50c per share and a market value of $4•00 per share. The cost of equity of the company is 9% per year. The business sector of GWW Co has an average price/earnings ratio of 17 times. The 8% bonds are redeemable at nominal (par) value of $100 per bond in seven years’ time and the before-tax cost of debt of GWW Co is 6% per year.
The expected net realisable values of the non-current assets and the inventory are $86•0m and $4•2m, respectively. In the event of liquidation, only 80% of the trade receivables are expected to be collectible.
Required:
Calculate the following values for GWW Co:
(i) debt/equity ratio (book value basis);
(ii) debt/equity ratio (market value basis).
Discuss the usefulness of the debt/equity ratio in assessing the financial risk of GWW Co.
Bar Co is a stock exchange listed company that is concerned by its current level of debt finance. It plans to make a rights issue and to use the funds raised to pay off some of its debt. The rights issue will be at a 20% discount to its current ex-dividend share price of $7·50 per share and Bar Co plans to raise $90 million.
Bar Co believes that paying off some of its debt will not affect its price/earnings ratio, which is expected to remain constant.
| income statement information | |
| $m | |
| turnover | 472 |
| cost of sales | 423 |
| ----- | |
| profit before interest and tax | 49 |
| interest | 10 |
| ----- | |
| profit before tax | 39 |
| tax | 12 |
| ----- | |
| profit after tax | 27 |
| ----- | |
| statement of financial position information | |
| $m | |
| equity | |
| ordinary shares ($1 nominal) | 60 |
| reserves | 80 |
| ----- | |
| 140 | |
| long-term liabilities | |
| 8% bonds ($100 nominal) | 125 |
| ----- | |
| 265 | |
| ----- |
The 8% bonds are currently trading at $112·50 per $100 bond and bondholders have agreed that they will allow Bar Co to buy back the bonds at this market value. Bar Co pays tax at a rate of 30% per year.
Required:
Calculate and discuss the effect of using the cash raised by the rights issue to buy back bonds on the financial risk of Bar Co, as measured by its interest coverage ratio and its book value debt to equity ratio.