The University has also provided your class with two components of its most recent financial
statements of its machine-shop that produces chairs. Prior to COVID-19, the machine-shop
contributed 4% to the University’s income; the trend appears to be falling since.
The University is contemplating purchasing some additional equipment at an initial cost of
$30 million, which they hope will turn around the earnings fortunes of the machine-shop.
Statement of Income for the period ending December 31:
2019 2018
$000 $000
Revenue 50,000 50,000
Cost of sales 31,000 30,000
Gross profit 19,000 20,000
Distribution costs 1,000 750
Administrative expenses 3,000 1,750
Operating profit before interest & tax 15,000 17,500
Interest 4,000 3,800
Operating before tax 11,000 13,700
Taxation 3,300 4,000
Profit for the year 7,700 9,700
Statement of Financial Position as at December 31:
2019 2018
Assets $000 $000
Property, plant & equipment 65,000 64,000
Current assets
Inventories 11,700 10,000
Receivables 8,500 9,000
Cash & cash equivalents 1,300 1,000
Total current assets 21,500 20,000
Total assets 86,500 84,000
Equity & liabilities
Ordinary share capital $1 each 35,000 35,000
Reserves 5,000 1,200
Total equity 40,000 36,200
10% Loan notes (2014) 35,000 35,000
Current liabilities 11,500 12,800
Total equity & liabilities 86,500 84,000
The purchase of the equipment is expected to increase annual sales by 55,000 chairs.
Investment in replacement equipment would be needed after five-years. The financial data on
the additional units to be sold is as follows:
5
Selling price per unit $5,000
Cost of production $2,000
Variable administrative and distributive expenses are expected to increase by
$2,200,000 per year as a result of the increase in capacity.
In addition to the initial investment in new equipment, $4,000,000 would need to be
invested in working capital
The full amount of the initial investment in new equipment of $30,000,000 will give
rise to capital allowances on a 25% per years reducing balance method. The scrap
value of the equipment after five years is expected to be negligible.
Tax liabilities are in the year in which they arise and the University machine-shop
pays tax at 30% of annual profits.
The Finance Director of the machine-shop has proposed that the $30.4 million
investment should be financed by an issue of loan notes at a fixed rate of 8% per
annum.
The machine-shop uses the after tax discount rate of 12% to evaluate investment
proposals. Straight- line depreciation method is used over the expected life of fixed
assets.
Average data for chair-making industry is as follows:
o Gearing 100%
o Interest covers 4 times
o Current ratio 2:1
o Inventory days 90 days.
Required:
a) Suggest alternative sources of finance that the University could use, outlining the
advantages and disadvantages of each.
b) Analyse and comment on the recent performance of the University machine-shop
c) Calculate the effect on the gearing and interest cover of the University machine-shop of
financing the proposed investment with an issue of loan notes and compare your results
with the sector averages.
