Question # 3

A summarized statement of financial position of Rufus is as follows.

$m

Assets less current liabilities 150

Debt capital (70)

80

Share capital (20 million shares of $1) 20

Reserves 60

80

The company's profits in the year just ended are as follows.

$m

Profit from operations 21.0

Interest 6.0

Profit before tax 15.0

Taxation at 30% 4.5

Profit after tax (earnings) 10.5

Dividends 6.5

Retained profits 4.0

The company is now considering an investment of $25 million. This will add $5 million each year to profits before interest and tax.

• There are two ways of financing this investment. One would be to borrow $25 million at a cost of 8% per annum in interest. The other would be to raise the money by means of issue of 5 million shares @ $5 each.

Assume that the rate of taxation will remain at 30% and that debt interest costs will be $6 million plus the interest cost of any new debt capital.

Required

a)Produce a profit forecast for next year, assuming that the new project is undertaken and is financed

i.by debt capital or

ii.by equity shares.

b)Calculate the earnings per share next year, with each financing method.

c)Calculate the effect on gearing as at the end of next year, with each financing method.

d)Explain whether either or both methods of funding would be acceptable.