FIN4801 Assignment 5 2024 (Detailed solution)

Question 1 (40 Marks) (Capital structure decision making, learning units 7, 13 and 14) Read the following case and then answer the required section below the case: Offices Ltd. is a construction company focused on office space, which in the past had a large market capitalisation and turnover, but, after the recent pandemic, finds itself struggling to recover to its past stature in the construction industry due to the lower demand for office space. The company has, over the past few years sold off all its subdivisions and is now focussed solely on its core competency of building offices. Demand for new offices has remained subdued since 2020, however, there is still enough demand for the company to stay afloat. The management of Offices Ltd (from hereon, management) believes that the company can operate in this environment and return healthy profits due to its experienced staff. Management believes in the turnaround plan and the prospects of the company and is sure that it will return to being a large competitor in its industry, however, it is not expected that the company will return to its size pre the pandemic. Due to low demand, the company is cash poor and management wishes to raise more funds to implement the proposed turn-around plan, which is based around reducing debt repayments (lowering financial leverage) and focusing on their core competency. Below follows some financial information regarding the company: • Current number of shares in issue: • Current share price: 30c • Current capital structure: Assets = R; Liabilities= R; Equity = R • Current EBIT (operating profit) = R • Current interest expense = R • Tax rate: 27% • Current beta: 1.9 • Risk free rate: 8% • Market risk premium: 5% The company has had to incur a lot of debt to stay afloat and is planning a rights issue to raise funds to repay some of its debts and to implement its turn-around plan. Management estimates that it needs R over and above any retained earnings to implement the turnaround plan while they wish to lower its debt by R to bring about better profitability due to reduced interest payments, together with more future flexibility. It is not expected that EBIT would change for the foreseeable future and that any effect of the turn-around plan would only be felt later. The company will, immediately, use R to retire debt to that amount, while the R for the turn-around plan would be kept as cash initially. The interest payment is expected to fall in line (proportionally) with the reduction in the amount of debt. Required: a.) If a company changes its capital structure, what do you expect would happen to its risk profile a