The following is an extract from the balance sheet of Leisure International plc at 30 June 2019:

000

Ordinary shares of 50p each 5,200

Reserves 4,850

9% preference shares of 1 each 4,500

14% debentures 5,000

Total long-term funds 19,550

The ordinary shares are quoted at 80 p. Assume that the market estimate of the next ordinary dividend is 4 p, growing thereafter at 12% per annum indefinitely. The preference shares, which are irredeemable, are quoted at 72 p and the debentures are quoted at par. Corporation tax is 35%.

D) Assume that instead of raising 5 m of 14% debentures, the company had raised the equivalent amount in preference shares giving the same yield as the existing preference capital.

You are required:

1. To demonstrate that the returns offered to investors in the two financial instruments are consistent with investor risk aversion;

2. To calculate how Leisure International plcs equity earnings would have been affected if the preference shares had been issued instead of the debentures.