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I don’t understand why current liabilities are not reduced when you reduce the debt by 360.
I also don’t understand why earnings are not increased by the amount saved on interest
they seem to include some items pertinent to what they are asking and ignore others. The answer book mentions 817 as the share buyback in the change of equity section. It must be a typo. i just would have thought that earnings adjustment is vital when you stop paying interestThe debt is a non-current liability (it is repayable in more than 1 year) and non-current liabilities have been reduced.
The first adjustment to the earnings in the answer is for the interest saved.
The total sale proceeds are 1,231. Of this, 360 is used to reduce the bet, which leaves 871 which is used to reinvest (in option 1) or to buyback shares (in option 2).
i understand the debt is a non current liability so i deducted the 360, but attached to the debt is interest they pay per annum (less tax) which should increase earning and cash or decrease current liabilities of interest owing. I got all that that you mentioned.
Also if there is a decrease in earnings what happens to the tax.
I have just realised as well (I think), the reason this is at masters level.
Am i correct in assuming that in option 2 where they have divided the 871 between the 54 and the 817 retained earnings they have, in their summary, cleverly left out share premium and so we deduct the 817 off the 1535, but actually that is share premium??Sorry to be a nuisance
You wrote before that you did not understand why current liabilities were not reduced. However I am pleased that you are clear about that point 🙂
If I understand you correctly, then you are now clear that the first adjustment to the earnings in the answer is with respect to the after-tax interest saving on the debt repaid.
Tax affects the earnings – not the other way round!! Tax is calculated on the taxable profit, and earnings are after charging tax. If the taxable profit falls, then the tax reduces, and the earnings fall by the after-tax fall in the profits.
There is no share premium account! Share premium accounts only exist when shares are issued at more than nominal value, and so shares are being issued here. They are have 1,231 from the sale proceeds, they are using 360 to rely debt, and the remaining 871 is used to buy back shares. They are paying 871 to shareholders and so total equity must reduce by 871. The share capital reduces by the nominal value of the shares bought back (54) and the remaining 817 reduces the reserves. (Cr Cash 871; Dr Share capital 54; Dr Reserves 817). This bit is really Paper F7 financial accounts rather than financial management.
I must sound very stupid to you, but here is the problem.
The Retained earnings are 1535 before they do option 1 or 2
The buyback of the shares is being done with the proceeds of the sale of the plant, not the retained earnings so if you want to ad the 871 as earnings after paying back the debt then thyen RE will be 871 plus 1535, so i thought the examiner was trying something funny with thew extra value on the shares over nominal value because if you look at BPP answer paper they (817) next to retained earnings of 1535 and (54) next to the nominal value
I was taught at ICB level that if you don’t pay interest on long term debt your earnings increase by the amount of the after tax interest you save ie 360 x 5.5% less the saving on the swap of 70 basis points x .35, but the answer has no changes in earnings from the saving. I do understand more than you thinkBut I have explained the first bit already.
They are paying to shareholders a total of 871 to buy back and cancel the shares. Therefore the total equity reduces by 871.
54 is subtracted from the share capital – the nominal value of the shares – and the remaining 817 is deducted from the reserves (retained earnings).
So the total equity on the SOFP is reduced by the 871 that is paid out tot he shareholders.
Why on earth do you want to increase the reserves when they have paid money out to the shareholders and therefore owe them less??With regard to the interest, I repeat – the very first adjustment to the earnings in the workings in the answer is: Add: interest saved on medium-term loan notes (net of tax).
It is 360M x 6.2% x 65%The 6.2% is because the interest is LIBOR of 5.5% plus 70 basis points. The 65% is to make it net of tax at 35%.
This is exactly as you are wanting to do, and it has been done in the answer!!!
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