Topic 8 Q1 Solution

Reserves and Cash Ideally Green Plc should use cash as the first option as this It is easier to use retained earnings than go to the trouble of obtaining external finance and have to live up to the demands of external finance providers. The investment is for $80 million and reserves and cash are much less than this. This would therefore not be an option. Also Green Plc has previously been able pay dividends so by using this limited cash available there will be even less funds to pay the dividends that the shareholder will be expecting as they have received constant dividends before.

Debt Finance Another option is to try and option a loan from a bank. This option is good as they will not give away any control of the business. Another benefit of this option is that the interest payable is tax deductable and therefore this method is usually cheaper than issuing shares. The disadvantage of this option is that interest has to be paid, there is not the same choice you would have with dividends. If in the future if profit reduces the interest payments will still have to be paid and Green Plc could producing a loss. At the moment Green Plc has a long term loan which runs out in 2012. They will need to renew this finance so obtaining further debt could be difficult as Green Plc will become more risky. At the moment the debt to equity ratio called gearing is 130/240 = 54% this measures the financial risk of the company. If the $80 million investment is financed by debt this ratio will increase to (130+80)/240 = 87.5%. This rise sends signals to investors and financiers that Green Plc could be a dangerous option and they could take their funding elsewhere, or increase fees. Equity Finance The final option is issuing shares to raise the additional $80. There are benefits to this option as this will increase gearing. Also there is no obligation to pay dividends unlike the interest mentioned above. The disadvantages of this option are that you give away more control of the business and the existing shareholders will have to share the profit with more people. If we analyse the current EPS, which shows how much could be paid as a dividend, we will see that at the moment the shareholders could receive 29/200 = $0.145. If we increase the number of share (assuming that the market price is the same as the nominal value) then this reduce the EPS to 29/280 = $0.104. The shareholders would not like sharing the profits and any analysis would see this as an issue.