Question 2 (Marks: 20)

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.

19; 20 2020

The Independent Institute of Education (Pty) Ltd 2020

Page 4 of 13

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:

Q.2.1 Calculate the earnings per share (EPS) using the target capital structure under

downturn conditions only.

(13)

Q.2.2 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)

Q.2.3 The directors of Palladium Limited have indicated that in future they wish to follow

the EBIT-EPS approach in determining their optimal capital structure. Explain to

the directors why you would advise against following this approach.