Mega Labs develops and manufactures medicines. The company has been successful duringthe past few years, due primarily to having discovered, patented, and successfully marketeddozens of new medicines.The Company started to increase its dividends to the shareholders since last three years. Lastyear, the Company distributed $5 million dividends ($1 million to the cumulative preferenceshareholders and $4 million to the ordinary shareholders). Annual net profit had been risingsteadily until two years ago, when it peaked at $25 million. Last year, increased competitioncaused net profit to decline to $18 million. Management expects profit to stabilize around thislevel for several years.Mega generates the following proposals:a) To issue 5 years bonds payable. However, the bond contract requires the company tolimit total dividends to not more than 25% of net profit.b) To buy back its own share when there is any idle cash.REQUIRED:Evaluate EACH of the above proposals from the perspective of Preference shareholders andOrdinary shareholders (treat each option separately).

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Asked Dec 11, 2019
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Mega Labs develops and manufactures medicines. The company has been successful during
the past few years, due primarily to having discovered, patented, and successfully marketed
dozens of new medicines.
The Company started to increase its dividends to the shareholders since last three years. Last
year, the Company distributed $5 million dividends ($1 million to the cumulative preference
shareholders and $4 million to the ordinary shareholders). Annual net profit had been rising
steadily until two years ago, when it peaked at $25 million. Last year, increased competition
caused net profit to decline to $18 million. Management expects profit to stabilize around this
level for several years.
Mega generates the following proposals:
a) To issue 5 years bonds payable. However, the bond contract requires the company to
limit total dividends to not more than 25% of net profit.
b) To buy back its own share when there is any idle cash.
REQUIRED:
Evaluate EACH of the above proposals from the perspective of Preference shareholders and
Ordinary shareholders (treat each option separately).
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Mega Labs develops and manufactures medicines. The company has been successful during the past few years, due primarily to having discovered, patented, and successfully marketed dozens of new medicines. The Company started to increase its dividends to the shareholders since last three years. Last year, the Company distributed $5 million dividends ($1 million to the cumulative preference shareholders and $4 million to the ordinary shareholders). Annual net profit had been rising steadily until two years ago, when it peaked at $25 million. Last year, increased competition caused net profit to decline to $18 million. Management expects profit to stabilize around this level for several years. Mega generates the following proposals: a) To issue 5 years bonds payable. However, the bond contract requires the company to limit total dividends to not more than 25% of net profit. b) To buy back its own share when there is any idle cash. REQUIRED: Evaluate EACH of the above proposals from the perspective of Preference shareholders and Ordinary shareholders (treat each option separately).

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Step 1

There are different ways of sourcing capital. They can be termed based  (Long-term or Medium-term or Short-term) or on the basis of ownership and control  (Owned or borrowed) or source of generation (Internal or External).

On the basis of ownership and control, 2 costs are to be considered while selecting the type of source, they are interest cost and cost of sharing ownership and control.

Owned funds – These are equity issued by the corporation to its various promoters and investors. The ownership rights are with the equity shareholders. Promoters invest the total initial capital and the subsequent issue is done to the outside investors. Any new issue of stock leads to dilution of ownership and control. The cost of raising capital is a one-time cost of issue and allocation of stocks. Example: Equity and retained earnings

Borrowed funds  - The amount required is financed from an outside source. Borrower gains a charge on the assets of the company and borrowed pays the cost of interest. Interest payments are periodic in nature and continue until the maturity or full repayment of the debt. There is no dilution of ownership and control in the case of borrowed funds. The cost of borrowed funds is low as interest expense is deductible for taxation purpose, this gives the business the benefit of leverage.       Examples:  Debt, Debentures, term loans, Bonds.

Step 2

Proposal 1

In order to stabilize net profit at $18 million per annum, the company issues bonds. As per the bond contract, total dividend payable would be restricted to 25% of Net Profit i.e. 18*25% = $4.5 million.

Cumulative preference shareholders have a right to receive dividend on their shares. Therefore, this proposal does effect the preference shareholders. As the preference dividend is fixed at $1 million, the ordinary shareholders are eligible for a maximum of $3.5 million. Payment of dividend to ordinary shareholders is not compulsory in nature. It is at the Board discretion to pay and the amount to pay.

Bonds have a charge on the assets of the company and Bond interest payment is a compulsory yearly payment.

Step 3

Proposal 2

The company wishes to use its idle cash by buy back of its ordinary shares. Dividend payment is not required to made for shares bought back.

Preference shares can only be redeemed but the option of buy back is not available, therefore preference dividend shall be paid to all preference shareholders. Buy back option is available ...

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