The board of directors of Western Ltd. is considering an expansion of production capacity following an...

  

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The board of directors of Western Ltd. is considering an expansion of production capacity following an increase in sales over the past two years. The most recent accounts for the business are set out below. Current assets Cash Accounts receivable Inventory Total current assets Property, plant, and equipment Land Buildings Less: Accumulated depreciation Machinery and equipment Less: Accumulated depreciation Furniture and fixtures Less: Accumulated depreciation. Total property, plant, and equipment Total assets Current liabilities Accounts payable Long-term debt Bank loans, 12% Total liabilities Shareholders' equity Common shares (40 million outstanding) Retained earnings Total shareholders' equity Total liabilities and shareholders' equity Sales revenue Earnings before interest and taxes Interest charges Western Ltd. Balance Sheet as at November 30, 2010 (in $ millions) Earnings before taxes Income tax expense (30%) Net income Dividend Addition to retained earnings for the year 23.0 6.0 32.0 21.0 10.0 2.0 2.0 22.0 14.0 5.0 17.0 11.0 Western Ltd. Income Statement and Retained Earnings Increase for the year ended November 30, 2010 8.0 20.0 20.0 20.0 19.0 ($ millions) 95.0 8.0 2.4 5.6 1.7 3.9 1.2 2.7 38.0 41.0 79.0 40.0 39.0 79.0 The business plans to invest a further $15 million in machinery and equipment and is considering two possible financing options. The first option is to make a one-for-four rights issue. The current market price per share is $2.00 and the rights shares would be issued at a discount of 25% on this mar- ket price. The second option is to take a further loan that will have an initial annual rate of interest of 10%. This is a variable rate and, while interest rates have been stable for a number of years, there has been recent speculation that interest rates will begin to rise in the near future. The outcome of the expansion is not certain. The management team involved in developing and implementing the expansion plans has provided three possible outcomes concerning earnings before interest and taxes for the following year: Change in earnings before interest and taxes from previous year +30% +10% -20% Optimistic Most likely Pessimistic The dividend per share for the forthcoming year is expected to remain the same as for the year ended November 30, 2010. Western Ltd. has a lower leverage ratio than most of its competitors. This has been in accordance with the wishes of the West family, which has a large shareholding in the company. The share price of the company has shown rapid growth in recent years and the P/E ratio for the business is 20.4 times, which is much higher than the industry average of 14.3 times. Costs of raising funds should be ignored. Required: (a) Prepare calculations that show the effect of each of the possible outcomes of the expansion program on: (i) Earnings per share (ii) The leverage ratio (based on year-end figures), and (iii) The times interest earned ratio of Western Ltd., under both of the financing options. (b) Assess each of the financing options available to Western Ltd. from the point of view of an existing shareholder and compare the possible future outcomes with the existing situation. The board of directors of Western Ltd. is considering an expansion of production capacity following an increase in sales over the past two years. The most recent accounts for the business are set out below. Current assets Cash Accounts receivable Inventory Total current assets Property, plant, and equipment Land Buildings Less: Accumulated depreciation Machinery and equipment Less: Accumulated depreciation Furniture and fixtures Less: Accumulated depreciation. Total property, plant, and equipment Total assets Current liabilities Accounts payable Long-term debt Bank loans, 12% Total liabilities Shareholders' equity Common shares (40 million outstanding) Retained earnings Total shareholders' equity Total liabilities and shareholders' equity Sales revenue Earnings before interest and taxes Interest charges Western Ltd. Balance Sheet as at November 30, 2010 (in $ millions) Earnings before taxes Income tax expense (30%) Net income Dividend Addition to retained earnings for the year 23.0 6.0 32.0 21.0 10.0 2.0 2.0 22.0 14.0 5.0 17.0 11.0 Western Ltd. Income Statement and Retained Earnings Increase for the year ended November 30, 2010 8.0 20.0 20.0 20.0 19.0 ($ millions) 95.0 8.0 2.4 5.6 1.7 3.9 1.2 2.7 38.0 41.0 79.0 40.0 39.0 79.0 The business plans to invest a further $15 million in machinery and equipment and is considering two possible financing options. The first option is to make a one-for-four rights issue. The current market price per share is $2.00 and the rights shares would be issued at a discount of 25% on this mar- ket price. The second option is to take a further loan that will have an initial annual rate of interest of 10%. This is a variable rate and, while interest rates have been stable for a number of years, there has been recent speculation that interest rates will begin to rise in the near future. The outcome of the expansion is not certain. The management team involved in developing and implementing the expansion plans has provided three possible outcomes concerning earnings before interest and taxes for the following year: Change in earnings before interest and taxes from previous year +30% +10% -20% Optimistic Most likely Pessimistic The dividend per share for the forthcoming year is expected to remain the same as for the year ended November 30, 2010. Western Ltd. has a lower leverage ratio than most of its competitors. This has been in accordance with the wishes of the West family, which has a large shareholding in the company. The share price of the company has shown rapid growth in recent years and the P/E ratio for the business is 20.4 times, which is much higher than the industry average of 14.3 times. Costs of raising funds should be ignored. Required: (a) Prepare calculations that show the effect of each of the possible outcomes of the expansion program on: (i) Earnings per share (ii) The leverage ratio (based on year-end figures), and (iii) The times interest earned ratio of Western Ltd., under both of the financing options. (b) Assess each of the financing options available to Western Ltd. from the point of view of an existing shareholder and compare the possible future outcomes with the existing situation.

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