Case Study Report
The following business situation has been presented to your firm for advice.
Ruby Traditions Ltd (the company) is asset rich but cash poor and is currently earning acceptable profits. The company has substantial long term borrowings and its loan contract with its major lender requires the company to maintain a minimum debt to assets ratio of 65%. In an attempt to raise more working capital, while minimising increases in the company’s debt to asset ratio, the directors are considering two proposals to fund proposed expansions.
Proposal 1 – Share issue
Ruby Traditions Ltd will issue 200,000 shares (described as preference shares) for a term of 10 years at $50 per share on the following terms:
• Preference shares rank after all other creditors, but before other shareholders for return of capital in any liquidation.
• The preference shares are cumulative and will pay an annual dividend of 6% per annum on 30 June each year.
• The preference shares are redeemable. At the end of 10 years, preference shareholders may choose between receiving a cash payment of $50 per share and receiving ordinary shares in Ruby Traditions Ltd. The number of ordinary shares received will be calculated as [($50/market price per share on 1 July 2026) + 1 share]. The market price of Ruby Traditions Ltd’s ordinary shares on 1 July 2016 is forecast to be $10.
• On 1 July 2016, Ruby Traditions Ltd could issue debt securities, without a conversion option, for a 10 year term at 7% interest per annum, returning the principal to debt holders at the end of the 10 year term.
• The directors believe the preference shares would be treated as equity.
Proposal 2 – Sale and leaseback of land and buildings
Ruby Traditions Ltd measures land and buildings using the cost model. The relevant values at 1 July 2016 are:
Lender Bank Ltd has made a sale and leaseback offer for Ruby Traditions Ltd’s land and buildings. Lender Bank Ltd will pay $10,000,000 to Ruby Traditions Ltd to purchase the land and buildings. Lender Bank Ltd indicates the leaseback would be an operating lease. The buildings will be demolished at the end of 10 years so that the residual value under the lease agreement is wholly attributable to the land but does not represent the estimated fair value of the land at the end of the lease. At the end of the lease term of 10 years, Lender Bank Ltd will sell the land and buildings for redevelopment and is certain of recovering the residual.
The terms of the contract for the leaseback of land and buildings were:
Carrying Amount
Fair Value
Remaining useful and economic life
Land
$4,000,000
$6,000,000
Building
$3,000,000
$6,000,000
10 years
The lease is non-cancellable
Lease payments paid 1 July each year
10 x $1,300,000
First payment
1 July 2016
Residual value of land on 30 June 2026
$1,250,120 not guaranteed by Ruby Traditions Ltd
Interest rate implicit in the lease
8%
You are required to individually prepare a report to the directors of Ruby Traditions Ltd to explain if the proposals would assist the company in meeting their objectives. You report should include:
• A determination of the impact of Proposal 1 as perceived by the directors.
• A determination of the impact of Proposal 2 as perceived by Lender Bank Ltd.
• A determination and explanation of how the proposed issue of preference shares in Proposal 1 should be classified in accordance with Australian Accounting standards.
• A determination and explanation of how the proposed leasing agreement relating to land and buildings in Proposal 2 should be classified in accordance with Australian Accounting Standards.
• The relevant journal entries, complying with AASB standards, required by Proposal 1 and Proposal 2 for the period 1 July 2016 to 30 June 2017, provided in the appendix to your report.


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