Business Expansion Assignment | Homework For You

Question 1 RED OIL Co wants to raise $20 million in order to expand its business and wishes to evaluate one possibility, which is an issue of 8% loan notes. Extracts from the financial statements of RED OIL Co are as follows. $m Income 140·0 Cost of sales and other expenses 112·0 –––––– Profit before interest and tax 28·0 Finance charges (interest) 2·8 –––––– Profit before tax 25·2 Taxation 7·6 –––––– Profit after tax 17·6 –––––– $m $m Equity finance Ordinary shares ($1 nominal) 25·0 Reserves 118·5 143·5 ––––– Non-current liabilities 36·0 Current liabilities 38·3 –––––– Total equity and liabilities 217·8 It is expected that investing $20 million in the business will increase income by 5% over the first year.

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Approximately 40% of cost of sales and other expenses are fixed, the remainder of these costs are variable. Fixed costs will not be affected by the business expansion, while variable costs will increase in line with income. RED OIL Co pays corporation tax at a rate of 30%. The company has a policy of paying out 40% of profit after tax as dividends to shareholders. Current liabilities are expected to increase by 3% by the end of the first year following the business expansion.

Average values of other companies similar to RED OIL Co: Debt/equity ratio (book value basis) 30% Interest cover 10 times Operational gearing (contribution/PBIT) 2 times Return on equity: 15% Required: (a) Assess the impact of financing the business expansion by the loan note issue on financial position, financial risk and shareholder wealth after one year, using appropriate measures. (20 marks) (b) Discuss the circumstances under which the current weighted average cost of capital of a company could be used in investment appraisal and indicate briefly how its limitations as a discount rate could be overcome. (20 marks) Get Finance homework help today