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 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.