The following is a summary of Binders plc's balance sheet for the year recently ended:

(millions of pounds)

RESOURCES

Cash and bank account balances 173 Total Current Assets 177 Fixed Assets 4 Other Current Assets Other non-current assets: 354 381 Total Assets 558 LIABILITIES & EQUITY 27 Total Non-Current Assets

Responsibilities

Total Non-Current Assets 381

Total Assets 558

LIABILITIES & EQUITY

Liabilities

Bank Overdraft 4

Other Current Liabilities 125

Total Current Liabilities 129

Bank term loans 96

Total Liabilities 225

Equity

- Ordinary Shares 90

- Retained Earnings 243

Total Equity 333

Total Liabilities & Equity 558

The Board of Directors of Binders plc wishes to make the following payments: 29 million for the acquisition of fixed assets, including a new headquarters building and several pieces of replacement machinery; 30 million for repayment instalments on bank term loans.

Payment of a 27 million annual dividend.

Binders plc did not make any money in the previous fiscal year. The company, which presently has a temporary overdraft with one of its bankers, has asked for a formal 90 million overdraft to enable it to make the following payments.

The bank has requested that the company make proper representations in its application for the loan.

The bank overdraft is recognized as both a current liability and a debt for the purposes of calculating relevant financial ratios because it is a loan that is repayable on demand.

Binders plc's CEO is concerned about the company's plans' potential influence on key financial indicators, which could jeopardize the company's ability to meet certain financial covenants (both maintenance and incurrence covenants) imposed by lenders.

Requirements:

(a) Determine two important balance sheet ratios and one other balance sheet measure used in financial covenants that are likely to be of special concern to Binders plc's CEO based on the facts presented. Calculate these before and after taking the recommended action, and explain why lenders are imposing such covenants.

(9 points)

(b) Explain what the term "representations" means in the context of the foregoing, including why they are required and what sectors they might cover. Examine two specific areas of worry for borrowers in terms of representations.

(6 points)

(c) Define the terms "maintenance covenants" and "incurrence covenants." What are the main aspects to consider when establishing financial covenants to ensure that monitoring and testing such covenants for compliance will not be a problem?

(5 points) (Total 20 marks)

5

Southee Limited, a UK construction company, plans to spend 10 million on new earthmoving equipment and is investigating the following potential sources of funding:

I A bank loan for the entire cost of the equipment, repayable over four years in equal annual instalments with a 5% annual interest rate, with the first instalment due one year after the loan is taken out.

(ii) A finance lease with a 223,000 monthly leasing rental. The first rental is paid in advance, with subsequent monthly payments for the next four years.

At the end of the four-year period, the equipment would have no residual value.

The Company Secretary receives a visitor from abroad who advises that leasing rather than buying the equipment is a better option. Southee's own capital would not be locked up because the lessor would acquire and own the equipment, according to the friend's logic. Southee Limited is heavily geared, and a friend has advised that leasing rather than borrowing to acquire the equipment might improve Southee Limited's balance sheet. The friend uses the rental car they used while visiting the United Kingdom as an illustration of the benefits of leasing.

Requirements:

(a) Determine the annual instalment that would be due if you took out a bank loan. Calculate how much of the principal payments and how much of the interest charges would be in each of the four years, as well as in total.

(5 points)

(b) What is the lessor's before-tax rate of return, as implied by the proposed lease agreement's conditions, and how does it compare to the rate of interest on the bank loan?

(4 points)

(c) Discuss the soundness and significance of the Company Secretary's friend's counsel.

(4 points)

(d) Discuss the advantages of leasing equipment rather than buying it with a bank loan for a company like Southee Limited.

(7 points)

(Total of 20 points)