Applying accounting theory    LO6, 8, 13, 14 Tropical Tours Ltd needs to raise $500 000 to finance the acquisition of a new tour bus. It approached an investment bank that proposed the following alternatives:

(a) the issue of 8%, cumulative preference shares for $500 000 with a fixed redemption date 5 years from the date of issue (8% cumulative preference shares)

(b) the issue of 10%, non-cumulative, preference shares for $500 000, redeemable at the option of the issuer (10% non-cumulative preference shares). The preference share issue is planned for 2019. The accountant prepared an abridged projected statement of financial position for Tropical Tours Ltd s at 30 June 2018, based on the company’s master budget. The projected statement of financial position excludes the effects of the proposed preference share issue or the investment in the new tour bus. Projected statement of financial position of Tropical Tours Ltd as at 30 June 2018 (abridged) $ $ Assets 2 500 000 Liabilities 1 500 000 Equity 1 000 000 2 500 000 2 500 000 Additional information • Tropical Tours Ltd estimates profit before interest and tax (EBIT) as $420 000. This estimate is based on prior years’ performance, adjusted for the effects of the additional tour bus. • Interest expense in relation to a bank loan included in ‘Liabilities’ = $100 000. • Tropical Tours Ltd’s bank loan includes a debt covenant which specifies a maximum leverage ratio (total liabilities/total assets) of 60%. • The company has investigated alternative sources of funding and found that most lenders require it to have maintained interest coverage (EBIT/Interest expense) greater than 3.0. • Management receives a bonus of 2% of profit before tax, provided the return on investment (EBIT/total assets) exceeds 12%. Required 1. Calculate Tropical Tours Ltd’s leverage ratio at 30 June 2018 based on the projected statement of financial position. 2. How should the 8% cumulative preference shares be classified in accordance with AASB 132/ IAS 32? Justify your classification. 3. Prepare a journal entry to record the annual dividend payable on the 8% cumulative preference shares. 4. Using the projected figures and estimates provided, calculate Tropical Tours Ltd’s leverage ratio and interest coverage assuming the company issues the 8% cumulative preference shares. 5. How should the 10% non-cumulative preference shares be classified in accordance with AASB 132/IAS 32? Justify your classification. 6. Prepare a journal entry to record the annual dividend payable on the 10% non-cumulative preference shares. 7. Using the projected figures and estimates provided, calculate Tropical Tours Ltd’s leverage ratio and interest coverage assuming the company issues the 10% non-cumulative preference shares. 8. Compare Tropical Tours Ltd’s profit before tax for each financing alternative. 9. Drawing on agency theory (refer chapter 2), explain which financing arrangement would be preferred by management. Where relevant, refer to your analysis of financial statement implications in parts 2 to 8.