Case Study: Shepherds Hut plc The most recent financial statements are given below for Shepherds Hut plc. Shepherds Hut plc is a producer and supplier of luxury shepherds huts. Up until five years ago they were a family owned business with all shareholders having been either family members or employees. However they are now listed on the stock exchange and so the structure of the business has significantly changed. The two most senior directors of Shepherds Hut plc, Henry and Humphrey and their families are keen to remain the majority shareholders in the business and are determined not to lose control of the business. But they are also keen to expand the business over the next five years. The current share price for 2018 is 2.80 and the company paid a dividend of 0.18 per share. This compares with the previous year 2017 when the share price was 4.25 and a dividend of 0.25 was payable to shareholders. Statement of financial position of Shepherds Hut plc as at 31 December 2018 ('000) 2017 ('000s) Current assets Cash Receivables Inventory 5 1259 1763 3027 61 1004 1194 2259 Non-current assets Motor vehicles Fittings Land and buildings 221 285 360 866 162 320 227 709 Total assets 3893 2968 Current liabilities Bank overdraft Trade payables Taxation 676 1370 215 2261 255 1147 332 1734 Non-current liabilities Loans 200 200 130 130 Total Liabilities 2461 1864 Share capital: 1 nominal value Retained profit Revaluation reserve Total equity 545 787 100 1432 483 621 0 1104 Total equity and liabilities 3893 2968 Income Statement of Shepherds Hut plc for the year ended 31 December 2018 4814 2017 5614 Revenue Cost of Sales: Opening stock Purchases 1194 3939 5133 1763 3370 1227 3616 4843 1194 3649 Less Closing stock Gross profit 1444 1965 less Overhead Costs Salaries Rental Depreciation Distribution costs Telecommunications Electricity, water, oil and gas Research & Development Marketing and sales costs 278 85 92 187 56 111 18 102 929 397 127 108 272 90 158 51 187 1390 Net profit before interest 515 575 Interest 156 53 Profit before Taxation 359 522 Taxation 193 292 Profit attributable to equity Shareholders 166 230 Extracts from the notes to the accounts: 1. A long-term loan amounting to 70,000 was repaid during the year and was replaced with a new loan of 140,000 repayable in 10 years time. 2. Land and Buildings were revalued in 2017 adding 60,000 to the value of Land giving a new value of 180,000 for Land and adding 40,000 to the value of Buildings to give a new valuation of 180,000 for Buildings. This gives a total of 100,000 as revaluation Reserves 2. Share capital: Shepherds Hut plc issued 62,000 new 1 shares in 2018. Question 1 (25 marks) To achieve the proposed expansion of the business Shepherds Hut plc need to purchase some new machinery to enable them to increase production. The three projects, A, B and C are detailed below. The company discounts all projects at a cost of capital of 12%. Year 0 Initial Investment Scrap Value Project A 29.000 1,000 Project B 64.000 2,000 Project C 65,000 2,500 Cashflows 8.000 12,000 10.000 11.000 19.000 24,000 35,000 3 12.000 18,000 18.000 18,000 39,000 4 5 You are required to answer the following: 1 Calculate the Payback period for each project. (3 marks) 2. Calculate the Net Present Value for each project. (6 marks) 3. Calculate the Accounting Rate of Return for each period. (6 marks) 4. State which project should be chosen, A, B or C. (1 mark) 5. Discuss the advantages and disadvantages of each of the methods of appraisal Payback method, Net Present Value and Accounting Rate of Return (9 marks) Question 2 (35 marks) You have been asked by the directors of Shepherd Hut plc, Henry and Humphrey, to analyse the financial performance of the company over the period 2017 to 2018 (two years). They are interested in all aspects of the business so you need to analyse all of the five key areas - Profitability, Investment, Efficiency, Liquidity and Gearing. You need to calculate ten different ratios (two from each of the five key areas) for each of the two years (2017 and 2018) giving a total of 20 calculations You need to give a full explanation/discussion of any changes over the two year period for each of the ten ratios. Please note that simply stating that a ratio has increased/decreased or risen/fallen will not be awarded any marks. Question 3 (20 marks) i) You are required to calculate the cost of debt for Shepherds Hut plc for 2017 and 2018 The tax rate for both years is 25%. The rate of interest for 2017 is 6% and for 2018 it is 8%. The market price of debt for both years is 88 per nominal 100. (4 marks) ii) You are required to calculate the cost of equity for Shepherds Hut plc for 2017 and 2018 using the dividend (Gordon) growth model. The growth rate is 2%. (2 marks) iii) Calculate the cost of equity using the Capital Asset Pricing Model (CAPM). The tax rate is 25%, the risk free rate of return is 3%, the return to the market is 10% and the beta is 1.8. (2 marks) iv) Using your cost of equity calculation for the Gordon Growth model in part (ii) above and your cost of debt calculations from parti) above calculate the Weighted Average Cost of Capital (WACC) for Shepherds Hut plc for 2017 and 2018. The proportions of equity and debt in the capital structure for each year can be taken from your ratio calculations in question 2 (4 marks) iv) Shepherds Hut plc currently uses a range of different sources of finance. They need to raise additional finance to fund their five year expansion. Which sources of finance would you recommend the business to use? You need to discuss four different sources. For each source of finance you need to discuss the advantage/disadvantages, the relevant costs associated with that source of finance and how this will impact on the capital structure and the risk of the business. (8 marks) Question 4 (20 marks) i) Discuss the following theories of capital structure - Traditional view and the Modernist view (Modigliani and Miller) both without and with Taxation. For the Modigliani and Miller without and with Taxation theories make sure that you discuss the assumptions that form the theory (14 marks) ii) List the different elements that make up the working capital of a business. State briefly what actions the business can take to change each element. (6 marks)