The University has also provided your class with two components of its most recent financial statements of its machine-shop that produces chairs. Prior to COVID-19, the machine-shop contributed 4% to

The University has also provided your class with two components of its most recent financial

statements of its machine-shop that produces chairs. Prior to COVID-19, the machine-shop

contributed 4% to the University’s income; the trend appears to be falling since.

The University is contemplating purchasing some additional equipment at an initial cost of

$30 million, which they hope will turn around the earnings fortunes of the machine-shop.

Statement of Income for the period ending December 31:

2019 2018

$000 $000

Revenue 50,000 50,000

Cost of sales 31,000 30,000

Gross profit 19,000 20,000

Distribution costs 1,000 750

Administrative expenses 3,000 1,750

Operating profit before interest & tax 15,000 17,500

Interest 4,000 3,800

Operating before tax 11,000 13,700

Taxation 3,300 4,000

Profit for the year 7,700 9,700

Statement of Financial Position as at December 31:

2019 2018

Assets $000 $000

Property, plant & equipment 65,000 64,000

Current assets

Inventories 11,700 10,000

Receivables 8,500 9,000

Cash & cash equivalents 1,300 1,000

Total current assets 21,500 20,000

Total assets 86,500 84,000

Equity & liabilities

Ordinary share capital $1 each 35,000 35,000

Reserves 5,000 1,200

Total equity 40,000 36,200

10% Loan notes (2014) 35,000 35,000

Current liabilities 11,500 12,800

Total equity & liabilities 86,500 84,000

The purchase of the equipment is expected to increase annual sales by 55,000 chairs.

Investment in replacement equipment would be needed after five-years. The financial data on

the additional units to be sold is as follows:


Selling price per unit $5,000

Cost of production $2,000

 Variable administrative and distributive expenses are expected to increase by

$2,200,000 per year as a result of the increase in capacity.

 In addition to the initial investment in new equipment, $4,000,000 would need to be

invested in working capital

 The full amount of the initial investment in new equipment of $30,000,000 will give

rise to capital allowances on a 25% per years reducing balance method. The scrap

value of the equipment after five years is expected to be negligible.

 Tax liabilities are in the year in which they arise and the University machine-shop

pays tax at 30% of annual profits.

 The Finance Director of the machine-shop has proposed that the $30.4 million

investment should be financed by an issue of loan notes at a fixed rate of 8% per


 The machine-shop uses the after tax discount rate of 12% to evaluate investment

proposals. Straight- line depreciation method is used over the expected life of fixed


 Average data for chair-making industry is as follows:

o Gearing 100%

o Interest covers 4 times

o Current ratio 2:1

o Inventory days 90 days.


a) Suggest alternative sources of finance that the University could use, outlining the

advantages and disadvantages of each.

b) Analyse and comment on the recent performance of the University machine-shop

c) Calculate the effect on the gearing and interest cover of the University machine-shop of

financing the proposed investment with an issue of loan notes and compare your results

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