bbs stores june 2009

[ayeshatabani]

hi John,
can i please know why in part a(i), there isn’t an impact on the retained earnings when debt is repaid and earnings reinvested in non current assets, and why is there an impact on retained earnings only when there is a share repurchase?

Thankyou

[John Moffat]

Part (a) is really a basic financial accounts question from earlier financial accounts exams (and the statement in the answer effectively shows the entries).

Neither repaying debt nor investing in non-current assets has no affect on the profit and therefore no effect on the retained earnings.

However repurchasing shares at a price more than the nominal value does effect retained earnings, because the excess paid over the nominal value is effectively a payment out of profits and reduces retained earnings.

[ayeshatabani]

what about the interest payments, dont they reduce the profit. Since we repay debt our profit shouldn’t be higher? And selling the property should also reduce our rental income?

In part (ii) they have made adjustments to earnings, to calculate revised earnings per share and in this they have made the adjustments i am referring to.

[ayeshatabani]

I also want to add another nagging point. I have calculated kd= risk free rate+spread.
They have used LIBOR+ spread. If i do this, will i be marked wrong. I refer to the part where we have to calculate wacc under both options.

[John Moffat]

Of course fewer interest payments will increase profits in the future, but check the dates. Part (a) is looking at the immediate effect on the SOFP, whereas part (b) is looking at the effect on future earnings.

You would lose some marks, but not many. The risk free rate is needed for the calculation of the cost of equity, but the question specifically says that debt is borrowed at LIBOR + spread.

[ayeshatabani]

ok, thankyou! Hopefully they never give such a question in the actual exam.

[John Moffat]

You are welcome 🙂

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