Kaplan Exam Kit, Qno. 45 Arwin

ARWIN

Arwin plans to raise $5m in order to expand its existing chain of retail outlets. It can raise
the finance by issuing 10% loan stock redeemable in ten years time, or by a rights issue at
$4.00 per share. The current financial statements of Arwin are as follows:

Statement of profit or loss for the last year

Sales revenue
Cost of sales

50,000
30,000

Gross profit
Administration costs

20,000
14,000

Profit before interest and tax
Interest

6,000
300

Profit before tax
Taxation at 30%

5,700
1,710

Profit after tax

3,990

Changes in equity

Dividends
Net change in equity (retained profits)
Statement of financial position

2,394
1,596

Net non-current assets
Net current assets .

20,100
4,960

25,060

Ordinary shares, par value 25c
Retained profit
12% loan stock (redeemable in six years)

2,500
20,060
2,500

25,060

The expansion of business is expected to increase sales revenue by 12% in the first year.
variable cost of sales makes up 85% of cost of sales. Administration costs increase by
5% due to new staff appointments. Arwin has a policy of paying out 60 of profit after tax
as dividends and has no overdraft.

Required:
(a) For each financing proposal, prepare the forecast statement of profit or loss after
one additional year of operation.
(5 marks)
(b) Evaluate and comment on the effects of each financing proposal on the following:
(i) Financial gearing
(ii) Operational gearing
(iii) Interest cover
(iv) Earnings per share.
(12 marks)
(c) Comment on the view that businesses are unlikely to have high financial gearing
and high operating gearing.
(3 marks)

(Total: 20 marks)

Please help me solve the part B of the question, as I’m confused with financial gearing part and its amounts.

Sincere thanks!