Strategic Financial Objectives

The current date is 31 May 2021.
Big Bonanza Ltd is listed on an international stock exchange. It has an issued share capital of
2 million ordinary shares. Most of the shares are held by large financial institutions.
The company currently has an overdraft of R70 million which is carrying an annual interest rate
of 10%. The company has no other borrowings.
The company’s summary statement of profit or loss for the year ended 31 May 2021 was as
follows:
R’000
Operating profit 22,000
Interest paid 7,000
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Profit before taxation 15,000
Taxation 3,000
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Profit after taxation 12,000
Ordinary dividend paid 3,000
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Retained profit for the year 9,000
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Earnings and dividends are expected to grow at a constant rate of 4% each year in perpetuity.
Assume that the dividend is paid on 31 May each year.
The company is now considering accepting a major new project which would commence on
31 May 2022. The project is a high-risk investment but the directors expect it to increase the
company’s annual growth rate of total earnings and total dividends from 4% to 7%. The project
would be financed by a 1-for-4 rights issue at an issue price of R10 on 31 May 2022.
The required return by equity shareholders is currently 10% each year, but the directors believe
it would rise to 12% each year if the new project is accepted.
One of the directors is concerned about the impact of the project on the overall risk of the
company. She is also concerned about the impact of the project on earnings per share. In
particular, she is concerned that, if earnings per share falls, the share price might be adversely
affected.10
Required:
2.1 Ignoring the impact of the new project, calculate the following at 31 May 2021:
(a) the price per share (using the dividend growth model)
(b) earnings per share
(c) dividend cover
(d) price-earnings ratio
(e) gearing (using market value for equity)
To calculate gearing use: debt / (debt+equity) (8 marks)
2.2 Write a memorandum to the directors of Big Bonanza Ltd which, as far as the
information permits, evaluates the potential impact of the new project at 31 May 2022
(including financing) on:
(a) the value of the company
(b) the risk profile of the company
(c) the earnings per share of the company.
Show any relevant calculations to support your arguments. (12 marks)