QUESTION 1

The directors of Palladium Limited have stated in the company's latest financial report that they believe the company's ideal target capital structure should be:

Equity = 60%

Debt = 30%

Preference shares = 10%

To achieve this target, the company would maintain the same total capital employed and either issue new shares and reduce debt, or buy back the shares and increase debt, whichever is necessary. They do not expect that either the share price or the cost of borrowing would be affected.

The current capital structure of Palladium Limited at 31 August 2019 consisted of the following:

Ordinary shares: 80 000 shares with a par value of R30 per share. These shares are currently trading at R45 per share.

Debt: The company has R12 000 000 in debt, with an interest rate of 8%.

Palladium Limited has 500 000 8% preference shares available to issue. The nominal value is R14 per share whilst they are expected to be sold for R24 per share on the Johannesburg Stock Exchange.

The directors have forecast that profits before interest and tax of R30 000 000 will be achieved in the forthcoming financial year unless there is further depreciation in the Rand due to a potential downgrade by the ratings agencies which would increase their operating costs, in which case they expect the profit to decline by a quarter (). Taxes are calculated at 28%.

Required:

1)Calculate the earnings per share (EPS) using the target capital structure under downturn conditions only. [13 marks]

2)Calculate the degree of financial leverage for Palladium Limited for the target capital structure and discuss whether the new capital structure is more or less risky than the current structure whose financial leverage was calculated at 1,04. [4 marks]

QUESTION 2

Chill Ltd sold 125 000 of its deluxe rooms last month in Cape Town. The variable cost involved in a one-night booking is R800 and the contribution ratio is 60%. The fixed costs per annum are R144 000 000 and accrues evenly throughout the year.

Chill Ltd has also incurred the following additional costs:

Interest on corporate bonds: R2 500 000

Preference dividends: R7 500 000

The company has 40 000 000 ordinary shares in issue and is subject to a corporate tax rate of 28%

Required:

1)Calculate the break-even units for the month. [5 marks]

2)At the current monthly unit sales level, calculate the degree of operating leverage. [5 marks]