QUESTION $2(12$ marks$)$

Orange $($Pty$)$ Ltd have two wholly owned subsidiaries, Purple $($Pty$)$ Ltd and Green $($Pty$)$ Ltd$.$

Extracts from Purple $($Pty$)$ Ltd$$s and Green $($Pty$)$ Ltd$$s financial statements for the last accounting period are shown below:

Purple $($Pty$)$ Ltd

Green $($Pty$)$ Ltd

R$$million

R$000$

Share capital

$20$

$1600$

Reserves

$55$

$1200$

Bank loan

$40$

$600$

Loan from Orange $($Pty$)$ Ltd

$80$

$500$

Additional information:

$$ The loan from Orange $($Pty$)$ Ltd to Purple $($Pty$)$ Ltd is at an annual interest rate of $8\%.$ The loan from Orange $($Pty$)$ Ltd was $25\%$ more than Purple $($Pty$)$ Ltd could have raised from the bank at that time. The tax authorities consider a company to be thinly capitalised if its gearing ratio $($debt : equity$)$ is above $50$:$50.$

$$ The loan from Orange $($Pty$)$ Ltd to Green $($Pty$)$ Ltd is at an annual interest rate of $4\%.$

$$ All the bank loans are at the market interest rate of $8\%$ per annum.

The tax rate is $27\%,$ and tax is payable in the year the liability arises.

$$ Green $($Pty$)$ Ltd has a weighted average cost of capital $($WACC$)$ of $11\%,$ the directors are of the opinion that an increase in debt will not influence the WACC.

Required:

$2\mathrm{.}1$ Evaluate the gearing ratio and determine if thin capitalisation rules will apply to Purple $($Pty$)$ Ltd$.$ Calculate the amount of interest payable that will be allowed for tax relief relating to Purple $($Pty$)$ Ltd$\text{'}$s loan from Orange $($Pty$)$ Ltd$.$

Show all calculations $(4$ marks$)$

$2\mathrm{.}2$ Calculate the amount of interest payable on the loan from Orange $($Pty$)$ Ltd to Green $($Pty$)$ Ltd and calculate and comment on the adjustments to profit needed for tax purposes for both companies.

Show all calculations $(4$ marks$)$

$2\mathrm{.}3$ Critically discuss the statements and$/$or arguments made by the directors of Green $($Pty$)$ Ltd$,$ per the information provided above relating to the weighted average cost of capital $($WACC$)(4$ marks$)$

$[$Question total: $12$ marks$]$

$[$CIMA adapted$]$