Chapter Three: Business and the Financial Markets

Questions

3.6 ‘Loans from banks are a good source of funding for my business. If my
business fails, I don’t have to apologise to anyone personally; it’s just a
book entry and it doesn’t hurt anybody.’ Is this true? Explain your
reasoning.

No. Although it is true that most defaulters don’t apologise for the loss and there is a
book entry, there is a loss to the bank. Ultimately, the shareholders bear the loss.
Sometimes, losses can appear to be irrelevant when share prices are booming but, if
one institution were to suffer a disproportionate amount of losses, its dividends and
share price would usually reflect that.

3.7 What are the primary financial markets? Why is it critically important for
the effective operation of the primary markets to have well-developed
secondary markets where investors can trade with confidence?

The primary markets are the markets in which securities are offered for the first time.
The secondary markets supply liquidity, price discovery and confidence to the primary
markets as well as allowing the management of risk.

3.10 What is a prospectus? Why do firms prepare these documents?

A prospectus is a document providing details of new issues to potential investors. They

are required by law, but also are necessary to inform and attract investors.

3.13 ‘Debts can be risky. You can lose business through having it.’ Is this true?
Explain your reasoning.

Yes, it is true. Being in debt puts any entity at more risk than a similar entity with no
debt. Debt must be serviced with interest payments and these reduce the cash available
for other uses. In addition, a debt with a variable loan rate can rapidly become more of
a burden when interest rates are rising.

Financial Problems
3.1 Alison Toogood owns and runs a toy store. Sales amounted to about
$400 000 last year and the cost of goods sold was about 70% of sales. Alison
spent another $80 000 on wages, rent, rates, phone, power, insurance and
other cash costs. She runs the business as a sole trader and drew $500 per
week for living expenses. The business as a going concern has been valued

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 Chapter Three: Business and the Financial Markets

at $360 000 (she refused an offer of this amount yesterday) plus the value
of the stock, which is about $90 000. She has a cheque account with a
$50 000 overdraft limit. The current balance in this account is $10 000 in
the red (negative). Currently she also has a fully drawn advance of $70 000
on which she paid last year about $6000 interest.
(a) What was the profit made by the toy store last year?

Profit = $400 000 × .3 – $80 000 = $40 000

(b) What is the value of Alison’s equity in the business?

Equity = $360 000 + $90 000 – $10 000 – $70 000 = $370 000

(c) What percentage of assets is funded by equity and what percentage

by debt?

Equity = 370 /450 = 82%; Debt = 80/450 = 18%

(d) What is the debt to equity ratio?

80/370 = 1:4.6

(e) If Alison negotiated another loan of $50 000 for a major increase in
stock levels, what would the new debt to equity ratio be? Would
Alison be exposed to more or less risk? Explain.

130/370 = 1: 2.8. More risk – debt to equity ratio has increased.

(f) Alison expects to be able to sell the first batch of the new lines of stock
within 2 to 3 months, so she decides to raise the funds by way of a 180-
day commercial bill. The bank quotes her 3% as the cost for the full
180-day period. As commercial bills are issued at a discount (that is,
interest due plus the principal equal the face value), about how much
will Alison get in cash for a bill with a $50 000 face value?

$50 000 / 1.03 = $48 544.

(g) Alison’s overdraft costs her about 8% p.a. Which source of funding
would you advise? Why?

Bill is cheaper at about 6% p.a., but she needs to be sure she will have the cash to repay
at maturity. The overdraft is normally not so prescriptive about timing of repayment.

3.3 Woolworths Ltd is another firm which has grown strongly in the 2004–05
year with expansion into new non-traditional trading areas. Here is the
liabilities portion of the 2005 balance sheet.
(a) Ignoring both the current and non-current provisions, what
proportion of total assets was funded by debt in each year, 2004 and
2005. What do the percentages tell us?

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 Chapter Three: Business and the Financial Markets

(b) Explain which segments of debt have increased and which decreased
in the 2004–05 year. How would each of these changes impact upon
the profits of the firm?
(c) What changes are reflected in the equity section of the balance sheet?
Why (do you think) did the directors make the decisions that
produced these results?
(d) What is the 2005 debt to equity ratio? Is this conservative or risky?

(a) 3380/6145 = 55%; 5954/8958 = 66.5% Both debt and assets increased but debt
increased faster than assets.
(b) All sections increased except current tax liabilities. The increases indicate
expansion in the business. Servicing debt decreases profits per se, but the debt
also indicates the increasing scale which in itself will increase profits.
(c) All sections increased except the Income notes. The directors have elected to
use debt more than equity to expand the firm.
(d) D/e = 6761/2197 = 3.08:1. This is not conservative. However, the markets and
institutions are evidently happy as the share price has been on a continual
upward trend.

© John Wiley and Sons Australia, Ltd 2008 3.3