TOPIC 3: LEVERAGE & CAPITAL STRUCTURE(35 marks)

Question 1

"Plastics R Us" Manufacturing Company Ltd, a company that manufactures disposable cups, boxes, bags and containers is planning to invest in new machinery costing $3 million.The revenues and costs arising from this investment are shown below:

$'000

Sales

2,700

Variable Cost of Sales

756

Other Fixed Operating Expenses including tax-allowable depreciation

851

Plastic R Us is considering financing the machinery exclusively by an issue of 8% bonds redeemable in 5 years time with a nominal value of $1,000.

Plastics R Us has shared its budgeted profit and loss statement for the year ended 30^th November 2018, as well as its budgeted statement of financial position as at 30^th November 2018 below.These statements DO NOT take into consideration the effects of the machinery purchase or the financing option.

"Plastics R US" Manufacturing Company Ltd

Profit and Loss Statement for the year ended 30^th November 2018

20X8

$000

Sales

21,000

Cost of Sales (100% variable costs)

12,500

Gross Profit

8,500

Other Operating Expenses (100% fixed costs)

3,720

Earnings Before Interest and Taxes (EBIT)

4,780

Interest

1,000

Earnings Before Tax

3,780

Tax

1,134

Earnings Available to Common Shareholders (EACS)

2,646

Dividends

1,323

Retained Earnings

1,323

Important information about "Plastics R US" costs:

-Cost of Sales comprises ONLY variable costs

-The corporation tax rate is 30%

-Dividend cover is 2:1

"Plastics R US" Manufacturing Company Ltd

Statement of Financial Position as at 30^th November 2018

2018

$000

Non-current assets

33,000

Current assets

13,000

TOTAL ASSETS

46,000

Equity, Share capital and Reserves

32,000

10% bonds 20X2

10,000

Current Liabilities

4,000

Total Liabilities

14,000

TOTAL EQUITY AND LIABILITIES

46,000

Using the data above complete the following:

a)Calculate a Profit and Loss Statement and a Statement of Financial Position for "Plastics R Us" to illustrate the effect of the additional $12 million investment.(Note: The additional $12 million investment will result in an increase in sales, operating expenses, financial expenses, assets, and liabilities and will also impact Gross Profit, E )

b)Calculate the firm's Degree of Operating Leverage (DOL) when sales were $21,000,000

c)Calculate the firm's Degree of Financial Leverage (DFL) when sales were $21,000,000

d)Calculate the firm's Degree of Total Leverage (DTL) when sales were $21,000,000

e)Using the DOL, DFL and DTL calculated in parts b to d, predict the impact of the investment on the firm's EBIT and EACS

f)Discuss whether changing the capital structure of "Plastics R US" (i.e. increasing the proportion of debt relative to equity) can lead to a reduction in its cost of capital and hence an increase in the value of the company