Selecting the source of finance — practice questions

Option 1 — Retained profit only ($120k): Insufficient for $300k warehouse — rejected unless project scaled down.

Option 2 — Full bank loan ($300k): Achieves target; no dilution; but interest cost and gearing rise — need cash flow to cover repayments.

Option 3 — Mix (recommended): Use $120k retained profit + $180k bank loan. Reduces interest and debt vs full loan; avoids share issue and dilution. Owners' control preserved.

Justification: Matches case preference (minimal dilution), uses available internal funds, and loan size is more likely approved by bank.

Step 1: Analyse the impact of the Debenture Issue (Debt Finance)

• Calculate new total interest:
  • Existing interest: $40m \times 5\% =$2m
  • New interest: $50m \times 7\% =$3.5m
  • Total interest: $2m +$3.5m = $5.5m$
• Calculate Profit After Tax (PAT):
  • PBIT: $20m$
  • Less Total Interest: $5.5m$
  • Profit Before Tax (PBT): $20m -$5.5m = $14.5m$
  • Less Tax (20%): $14.5m \times 0.20 =$2.9m
  • PAT: $14.5m -$2.9m = $11.6m$
• Calculate Earnings Per Share (EPS):
  • EPS = PAT / Number of Shares = $11.6m / 100m =$0.116
• Impact on Gearing: Gearing will significantly increase as debt rises from $40m to$90m.

Step 2: Analyse the impact of the Rights Issue (Equity Finance)

• Calculate new shares issued:
  • $50m /$2.50 per share = 20m new shares
  • Total shares: 100m + 20m = 120m shares
• Calculate Profit After Tax (PAT):
  • PBIT: $20m$
  • Less Interest (existing only): $2m$
  • Profit Before Tax (PBT): $20m -$2m = $18m$
  • Less Tax (20%): $18m \times 0.20 =$3.6m
  • PAT: $18m -$3.6m = $14.4m$
• Calculate Earnings Per Share (EPS):
  • EPS = PAT / Number of Shares = $14.4m / 120m =$0.120
• Impact on Gearing: Gearing will decrease as equity increases by $50m while debt remains at $40m.

Step 3: Recommendation and Justification

Recommendation: The Rights Issue is the recommended option.

Justification: Although the rights issue leads to dilution of ownership, it is financially less risky. It results in a higher Earnings Per Share ($0.120 vs$0.116) based on current profits and strengthens the company's balance sheet by reducing gearing. The debenture issue would increase financial risk due to higher fixed interest costs and a much higher gearing ratio. For a major strategic move like international expansion, which carries its own operational risks, choosing the lower-risk financing option is a more prudent strategy.