June 2013 Q#4

You are going to have to be more specific as to which bits of the examiners answer you are not clear about (otherwise I would really only be effectively copying out the answer, which would be a bit pointless 🙂 )

You will know from my lectures what we mean by the earnings per share and by the interest cover, and it is therefore effectively preparing a profit statement for each of the two options.

There is no 8% !!

The question says that the funds invested will earn a before tax-return of 18%.
Therefore the profit (before tax) will increase by 18% of the funds raised under each option (which you should have no problem with).
Since there is tax at 20%, then the increase in profit after tax will be 80% of the before tax increase. Under option 2 there is no extra interest to pay, so you can then get the total profits available for shareholders and then the earnings per share.

Under option 3, again the profits will go up by 18% of the funds invested. However there will be more interest payable (because they issued bonds). So now you can calculate the new total profit after interest. Take 80% of it (because of tax at 20%) and you have the new profit after tax. Divide by the number of shares and you have the earnings per share.

This is all covered in my lectures (although is more basic financial accounts than financial management 🙂 )