Interest saved totals $1,432,000 ($1,296,000 + $136,000). The reduction in investment of $25 million will lose
$3,750,000, at a rate of return of 15%. Net impact is $2,318,000 loss which is subtracted from earnings as a reduction
from profit after tax and deducted from current assets as a cash expense (presumably). Overall therefore the profit is
reduced by $318,000 [$2,000,000 – $2,318,000].
If the profit from the sale of the asset is assumed to be $1,600,000 ($2,000,000 less tax), then the statement of financial
position, EPS and gearing figures will all change to reflect this.
Discussion
Proposals 1 and 3 appear to produce opposite results to each other. Proposal 1 would lead to a small increase in the earnings
per share (EPS) due to a reduction in the number of shares although profits would decrease by approximately 5%, due to the
increase in the amount of interest payable as a result of increased borrowings. However, the level of gearing would increase
substantially (by about 30%).
With proposal 3, although the overall profits would fall, because of the lost earnings due to downsizing being larger than the
gain in interest saved and profit made on the sale of assets, this is less than proposal 1 (1·2%). Gearing would reduce
substantially (19·2%).
Proposal 2 would give a significant boost in the EPS from 21·67c/share to 23·10c/share, which the other two proposals do
not. This is mainly due to increase in earnings through extra investment. However, the amount of gearing would increase by
more than 13%.
Overall proposal 1 appears to be the least attractive option. The choice between proposals 2 and 3 would be between whether
the company would prefer larger EPS or less gearing. This would depend on factors such as the capital structure of the
competitors, the reaction of the equity market to the proposals, the implications of the change in the risk profile of the
company and the resultant impact on the cost of capital. Ennea Co should also bear in mind that the above are estimates
and the actual results will probably differ from the forecasts.
(Note: credit will be given for alternative relevant comments and suggestions)
(b) Asset securitisation in this case would involve taking the future incomes from the leases that Ennea Co makes and converting
them into assets. These assets are sold as bonds now and the future income from lease interest will be used to pay coupons
on the bonds. Effectively Ennea Co foregoes the future lease income and receives money from sale of the assets today.
The income from the various leases would be aggregated and pooled, and new securities (bonds) issued based on these. The
tangible benefit from securitisation occurs when the pooled assets are divided into tranches and tranches are credit rated. The
higher rated tranches would carry less risk and have less return, compared to lower rated tranches. If default occurs, the
income of the lower tranches is reduced first, before the impact of increasing defaults move to the higher rated tranches. This
allows an asset of low liquidity to be converted into securities which carry higher liquidity.
Ennea Co would face a number of barriers in undertaking such a process. Securitisation is an expensive process due to
management costs, legal fees and ongoing administrative costs. The value of assets that Ennea Co wants to sell is small and
therefore these costs would take up a significant proportion of the income. High cost implications mean that securitisation is
not feasible for small asset pools.
Normally asset pools would not offer the full value of the asset as securities. For example, only 90% of the asset value would
be converted into securities, leaving the remaining 10% as a buffer against possible default. This method of credit
enhancement would help to credit-rate the tranches at higher levels and help their marketability. However, Ennea Co would
not be able to take advantage of the full asset value if it proceeds with the asset securitisation.
(Note: credit will be given for alternative relevant comments and suggestions)
