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Greetings Tutor, I hope you are doing well, can you please help me with a small question related to TIN Co. (Match/June 2018).
Before Considering Business Expansion, Tin Co’s Profit After Tax $1000K.
After considering Business Expansion using Equity Financing, Tin Co’s Profit After tax $1249K
After considering Business Expansion using Equity Financing, Tin Co’s Profit After tax $1124K.
When Calculating the Gearing, for Req V.
Equity Gearing (Post Right Issue)
4500/(7988+2000) = 45.1%
Although the impact of Right Share issue $ 2 Million has been incorporated but what about the increased Net Profit because of expansion shouldn’t’t that be added to Reserves?Similarly
Equity Gearing (Post Bond Issue)
6500/7988 = 81.4%
Again $2 Million issue of loan notes had been incorporated, but what about the increase in Net Profit because of Expansion shouldn’t that be added to Reserves?The increase in net profit due to business expansion should indeed be considered when calculating the equity gearing ratio. However, the profit after tax from the expansion is typically reflected in the retained earnings, which are already included in the equity calculation.
For the equity gearing ratio post-right issue, the calculation of 4500/(7988+2000) = 45.1% incorporates the right share issue, but the additional profit from the expansion is not directly added to the reserves for the gearing calculation. Instead, it is assumed that the retained earnings already account for the profits generated.
Similarly, for the equity gearing ratio post-bond issue, the calculation of 6500/7988 = 81.4% includes the loan notes, but again, the increased net profit from the expansion is reflected in the retained earnings and does not need to be added separately for the gearing calculation.
In summary, while the increased profits from expansion are important, they are already factored into the retained earnings used in the gearing calculations.
Thank-you Tutor, but I’m still a bit confused.
Considering company’s financial position prior to any expansion.
It has Ordinary Shares of $2500 and Retained Earnings of $5488, which totals up to $ 7988.
Current D/E using book (nominal) values = 4,500/(2,500 + 5,488) = 4,500/7,988 = 56.3%Post Right Issue.
Where additional 500K shares for $2000K would be issued.
Equity finance D/E using book (nominal) values = 4,500/(7,988 + 2,000) = 4,500/9,988 = 45.1%
So post expansion, we are simply adding $2000K, which is the amount of right issue proceeds.So where and how, we added the additional profit from expansion? Because 2000 + 7988 (2500+5488). The retained earnings amount of 5488 had been same in both cases. Shouldn’t it increase
Whilst the new equity raised from the rights issue ($2000K) is added to the equity base, the retained earnings remain unchanged until the profits are formally recognised and added to the reserves in future financial statements. expansion; they will only increase once those profits are realised and reported in the financial statements.
Thus, the calculation of the debt-to-equity ratio post-right issue uses the existing retained earnings without the additional profit from the expansion.
Again, the retained earnings of $5488 do not increase immediately due to the anticipated profits from the expansion; they will only increase once those profits are realised and reported in the financial statements. Thus, the calculation of the debt-to-equity ratio post-right issue uses the existing retained earnings without the additional profit from the expansion.
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