Oltre il Giardino SpA, a medium-sized listed company, is considering two schemes to finance its next expansion.
1. The first is to raise EUR 8 million by means of a long-term loan from its bankers. Interest would be charged at 2 per cent above base rate which you should assume currently stands at 5 per cent. The loan would be repayable in equal annual instalments over five years starting on 1 April 2007 and finishing on 1 April 2011. The bank requires an agreement to the following covenants. Firstly, an interest cover of at least two times must be maintained and, secondly, the debt-to-equity ratio is not to exceed 1.
2. The other scheme is to raise EUR 8 million by issuing 2 million ordinary shares at EUR 4 each.
The following extracts have been taken from the company's records:
|
Years ended 30 September
|
2005
|
2004
|
2003
|
|
No. of EUR 1 ordinary shares(millions)
|
10
|
10
|
10
|
| |
| Amounts in millions of euro |
|
|
|
|
Stockholder's equity
|
36
|
34
|
32
|
|
Loans
|
26
|
20
|
18
|
|
|
62
|
54
|
50
|
| |
|
EBIT
|
9.3
|
5.2
|
8
|
|
Interest expense
|
3
|
2.8
|
2.4
|
EBIT for the year ending 30 September 2006 is forecast at EUR 10 million and the dividends are forecast at EUR 0.20 per share. Use a corporate tax rate of 35 per cent in your calculations.
(a) Calculate the following ratios for 2006 for each of the debt-and-equity alternative: (i) interest cover (ii) debt-to-equity ratio.
(b) Using the information just mentioned, and any other ratios you consider relevant, state with reasons which scheme you would recommend.