Rights Issue Practice Flashcards
Issue one: finance decision
Eco’s directors wish to raise £10 million of finance to fund three investments which will provide additional energy from renewable resources.
The combined net present value of the three investments is expected to be £1.5 million
The finance director has identified two alternative sources of finance to raise the funds required.
1-for-4 rights issue
- £10 million could be raised by a 1-for-4 rights issue on 1 October 20X1, priced at a discount on the current market value of Eco’s shares
- Eco has in issue 20 million ordinary shares which are trading at £2.40 per share on September 20X1
6% redeemable bonds
- Alternatively, £10 million could be raised by an issue of five-year redeemable bonds with a coupon rate of 6%
- The bonds would be issued on 1 October 20X1 and would be redeemed on 30 September 2026 at par value
- Assets from the three investments would need to be used as security for these bonds
Bonds issued by other listed companies in Eco’s market sector have typically offered a gross redemption yield of 7% pa. However, the finance director has suggested that Eco should apply to the Climate Bonds Standards Board to request that the bonds are recognised as ‘green bonds’.
Investors typically require a lower gross redemption yield on green bonds because they receive tax incentives. The finance director has estimated that investors would only require a gross redemption yield of 6.25% pa if the bonds were classed as green bonds.
a) Assuming a 1-for-4 rights issue is made on 1 October 20X1, calculate the theoretical ex-rights price of one ordinary share and explain why this may be different to the actual ex-rights price.
Number of shares issued: 1 for 4 issue on 20 million shares = 5 million shares
Issue price per share: £10 million / £5 million = £2.00 per share
Theoretical ex-rights price:
20 million @ 2.40 per share = £48 million
5 million shares @ 2.00 per share = £10 million
—-
£58 million
Total MV = £59.5 million
Total shares = 20m + 5m = 24 million
TERP = 59.4m/25m = £2.38
The actual share price will depend on how the market reacts to the rights issue (eg, whether it is fully taken up)
Additionally, it will depend on how the market reacts to the planned investments
Additionally, the share price could be affected by general market conditions or events which affect market confidence
Issue one: finance decision
Eco’s directors wish to raise £10 million of finance to fund three investments which will provide additional energy from renewable resources.
The combined net present value of the three investments is expected to be £1.5 million
The finance director has identified two alternative sources of finance to raise the funds required.
1-for-4 rights issue
- £10 million could be raised by a 1-for-4 rights issue on 1 October 20X1, priced at a discount on the current market value of Eco’s shares
- Eco has in issue 20 million ordinary shares which are trading at £2.40 per share on September 20X1
6% redeemable bonds
- Alternatively, £10 million could be raised by an issue of five-year redeemable bonds with a coupon rate of 6%
- The bonds would be issued on 1 October 20X1 and would be redeemed on 30 September 2026 at par value
- Assets from the three investments would need to be used as security for these bonds
Bonds issued by other listed companies in Eco’s market sector have typically offered a gross redemption yield of 7% pa. However, the finance director has suggested that Eco should apply to the Climate Bonds Standards Board to request that the bonds are recognised as ‘green bonds’.
Investors typically require a lower gross redemption yield on green bonds because they receive tax incentives. The finance director has estimated that investors would only require a gross redemption yield of 6.25% pa if the bonds were classed as green bonds.
b) Based on the theoretical ex-rights price calculated above (£2.38), show the impact that the rights issue would have on the wealth of an Eco shareholder who currently owns 5,000 shares and who:
- Takes up all of the rights
- Sells all of the rights
- Takes no action
Current wealth = 5,000 shares @ 2.40 = £12,000
Takes up all of the rights:
Investment ex-rights: 6,250 shares @ £2.38 = £14,875
Cost of extra shares: 1,250 @ £2.00 = (£2,500)
—–
£12,375
Increase in wealth = £12,375 - 12,000 = £375
Sells all of the rights:
Investment ex-rights: 5,000 shares @ £2.38 = £11,900
Sale of rights: 1,250 shares @ £0.38 = £475
—–
£12,375
Increase in wealth = £12,375 - 12,000 = £375
Does nothing:
Investment ex-rights: 5,000 shares @ £2.38 = £11,900
Decrease in wealth = £12,000 - 11,900 = (£100)
Issue one: finance decision
Eco’s directors wish to raise £10 million of finance to fund three investments which will provide additional energy from renewable resources.
The combined net present value of the three investments is expected to be £1.5 million
The finance director has identified two alternative sources of finance to raise the funds required.
1-for-4 rights issue
- £10 million could be raised by a 1-for-4 rights issue on 1 October 20X1, priced at a discount on the current market value of Eco’s shares
- Eco has in issue 20 million ordinary shares which are trading at £2.40 per share on September 20X1
6% redeemable bonds
- Alternatively, £10 million could be raised by an issue of five-year redeemable bonds with a coupon rate of 6%
- The bonds would be issued on 1 October 20X1 and would be redeemed on 30 September 2026 at par value
- Assets from the three investments would need to be used as security for these bonds
Bonds issued by other listed companies in Eco’s market sector have typically offered a gross redemption yield of 7% pa. However, the finance director has suggested that Eco should apply to the Climate Bonds Standards Board to request that the bonds are recognised as ‘green bonds’.
Investors typically require a lower gross redemption yield on green bonds because they receive tax incentives. The finance director has estimated that investors would only require a gross redemption yield of 6.25% pa if the bonds were classed as green bonds.
c) Assuming redeemable bonds are issued on 1 October 20X1, calculate the issue price per bond and the total nominal value of the bonds that will have to be issued to give the gross redemption yield required by investors if:
- the bonds are not recognised as green bonds, and
- the bonds are recognised
Not recognised as green bonds:
Rate of return required over the period: 0.07
Number of periods: 5
The amount of interest paid in a single period: 6
Future value (paid at maturity): 100
Present value (issue price): 95.90
PV = Excel, PV(0.07, 5, 6,100)
Total number of bonds required = £10 million / 95.90 = 104,275 bonds
Total market value = 104,275 bonds x £100 = £10,427,500
Recognised as green bonds:
Rate of return required over the period: 0.0625
Number of periods: 5
The amount of interest paid in a single period: 6
Future value (paid at maturity): 100
Present value (issue price): 98.95
PV = Excel, PV(0.0625, 5, 6,100)
Total number of bonds required = £10 million / 98.95 = 101,061 bonds
Total market value = 101,061 bonds x £100 = £10,106,100
Issue one: finance decision
Eco’s directors wish to raise £10 million of finance to fund three investments which will provide additional energy from renewable resources.
The combined net present value of the three investments is expected to be £1.5 million
The finance director has identified two alternative sources of finance to raise the funds required.
1-for-4 rights issue
- £10 million could be raised by a 1-for-4 rights issue on 1 October 20X1, priced at a discount on the current market value of Eco’s shares
- Eco has in issue 20 million ordinary shares which are trading at £2.40 per share on September 20X1
6% redeemable bonds
- Alternatively, £10 million could be raised by an issue of five-year redeemable bonds with a coupon rate of 6%
- The bonds would be issued on 1 October 20X1 and would be redeemed on 30 September 2026 at par value
- Assets from the three investments would need to be used as security for these bonds
Bonds issued by other listed companies in Eco’s market sector have typically offered a gross redemption yield of 7% pa. However, the finance director has suggested that Eco should apply to the Climate Bonds Standards Board to request that the bonds are recognised as ‘green bonds’.
Investors typically require a lower gross redemption yield on green bonds because they receive tax incentives. The finance director has estimated that investors would only require a gross redemption yield of 6.25% pa if the bonds were classed as green bonds.
Identify the benefits for Eco of issuing green bonds and suggest two reasons why Eco’s bonds may qualify as green finance
- Eco would need to issue fewer bonds
- Eco would need to pay less interest
- Eco would pay less money to redeem the bonds
- Green bonds may be more attractive to ethical investors so risk of failure of issue is less
Reason:
- Eco are investing in (or have invested in) renewable energy
- Eco’s mission is to minimise the environmental impact of the energy they provide
Issue one: finance decision
Eco’s directors wish to raise £10 million of finance to fund three investments which will provide additional energy from renewable resources.
The combined net present value of the three investments is expected to be £1.5 million
The finance director has identified two alternative sources of finance to raise the funds required.
1-for-4 rights issue
- £10 million could be raised by a 1-for-4 rights issue on 1 October 20X1, priced at a discount on the current market value of Eco’s shares
- Eco has in issue 20 million ordinary shares which are trading at £2.40 per share on September 20X1
6% redeemable bonds
- Alternatively, £10 million could be raised by an issue of five-year redeemable bonds with a coupon rate of 6%
- The bonds would be issued on 1 October 20X1 and would be redeemed on 30 September 2026 at par value
- Assets from the three investments would need to be used as security for these bonds
Bonds issued by other listed companies in Eco’s market sector have typically offered a gross redemption yield of 7% pa. However, the finance director has suggested that Eco should apply to the Climate Bonds Standards Board to request that the bonds are recognised as ‘green bonds’.
Investors typically require a lower gross redemption yield on green bonds because they receive tax incentives. The finance director has estimated that investors would only require a gross redemption yield of 6.25% pa if the bonds were classed as green bonds.
Outline any other factors that Eco’s board of directors should consider when deciding whether the finance required should be raised by a rights issue or an issue of redeemable bonds.
- The bonds would be secured against assets of the investment so assets can’t be disposed of easily
- The bonds are redeemable in five years/ the shares will not need to be repaid
- The bonds will increase gearing / the rights issue will reduce gearing
- The new finance will have an impact on other ratios (e.g. earnings per share, interest cover)
- Additional annual dividends may need to be paid after the rights issue
- Changes in finance are likely to have an impact on Eco’s cost of capital
- Issue costs are lower for debt
- Industry gearing, interest cover etc
Issue two; Investment Decision
Eco’s board of directors plans to invest the funds raised in the three renewable energy projects outlined below:
Project 1: Wind Farm
- Investment required: £4,500,000
- NPV: £540,000
Project 2: Solar Farm
- Investment required: £3,000,000
- NPV: £510,000
Project 3: Hydro-electricity station
- Investment required: £2,500,000
- NPV: £450,000
Investment required total = £10m
NPV total: £1.5m
Due to uncertainties in the financial markets, the directors are concerned that Eco may not be able to raise the full funds required.
The directors would like to know what combination of projects should be chosen if the total amount of funds raised is only £7 million, assuming that all three projects are fully divisible.
Whilst all three projects will provide additional energy for the local community from renewable resources, there have been negative media reports about the impact that hydro-electricity stations can have on wildlife in the rivers where the stations operate.
a) Explain the difference between hard and soft capital rationing and identify which type of capital rationing applies to Eco if only £7 million is raised
- Hard capital rationing is when external capital markets limit the supply of funds to a company
- Soft capital rationing is when the firm imposes its own internal constraints on the amount of funds used to finance projects
- This issue assumes that the company will only be able to raise £7 million of finance and that no other funds are available. Therefore, it is an example of hard capital rationing
Issue two; Investment Decision
Eco’s board of directors plans to invest the funds raised in the three renewable energy projects outlined below:
Project 1: Wind Farm
- Investment required: £4,500,000
- NPV: £540,000
Project 2: Solar Farm
- Investment required: £3,000,000
- NPV: £510,000
Project 3: Hydro-electricity station
- Investment required: £2,500,000
- NPV: £450,000
Investment required total = £10m
NPV total: £1.5m
Due to uncertainties in the financial markets, the directors are concerned that Eco may not be able to raise the full funds required.
The directors would like to know what combination of projects should be chosen if the total amount of funds raised is only £7 million, assuming that all three projects are fully divisible.
Whilst all three projects will provide additional energy for the local community from renewable resources, there have been negative media reports about the impact that hydro-electricity stations can have on wildlife in the rivers where the stations operate.
b) Assuming that £7 million is available to interest, determine the combination of projects that would maximise Eco’s shareholders’ wealth
The profitability indexes of the three projects is as follows:
- Project 1: £540k / £5,400k = 0.12
- Project 2: £510k / £3,000k = 0.17
- Project 3: £450k / £2,500k = 0.18
Project 3 is the most profitable, followed by 2 and then 1 is the least profitable
To maximise shareholder wealth, the funds should be invested as follows:
7,000,000 to invest
Project 3, 100% investment (2,500k)
—
4,500k remaining
Project 2, 100% investment
(3,000k)
—–
1,500k remaining
Project 1, 1,500k/4,500k = 33.33% investment
(1,500k)
—-
0 remaining
Issue two; Investment Decision
Eco’s board of directors plans to invest the funds raised in the three renewable energy projects outlined below:
Project 1: Wind Farm
- Investment required: £4,500,000
- NPV: £540,000
Project 2: Solar Farm
- Investment required: £3,000,000
- NPV: £510,000
Project 3: Hydro-electricity station
- Investment required: £2,500,000
- NPV: £450,000
Investment required total = £10m
NPV total: £1.5m
Due to uncertainties in the financial markets, the directors are concerned that Eco may not be able to raise the full funds required.
The directors would like to know what combination of projects should be chosen if the total amount of funds raised is only £7 million, assuming that all three projects are fully divisible.
Whilst all three projects will provide additional energy for the local community from renewable resources, there have been negative media reports about the impact that hydro-electricity stations can have on wildlife in the rivers where the stations operate.
With reference to the concerns raised in the media reports, comment on whether the combination of projects that you have identified in (b) above is consistent with Eco’s mission: “to minimise the environmental impact of providing energy to the local community”
The combination of projects included prioritises the investment in the hydro-electricity plant over the wind farm.
However, there have been some negative media reports about the environmental impact of hydro-electrical plants.
To achieve Eco’s mission of ‘minimising the environmental impact’ it may be better to prioritise the investment to wind farms instead.
However, the media reports about the negative impact on the environment may not be accurate. (Or we do not know the impact of wind and solar farms)
Sentry Underwood Plc (Sentry) is a large, listed UK drinks manufacturer. Sentry’s recent profitability has deteriorated because of increased competition and a volatile consumer market. As a result, Sentry’s board is considering a major change in the company’s trading strategy will cost £20 million to implement. The board has decided that this investment will be funded either via a rights issue or an issue of debentures. Jenna Helier is Sentry’s finance director and she is an ICAEW CA.
Sentry’s other directors have asked her to provide information to help them decide on the source of funding for the new investment.
Extracts below:
Income statement for the year to 28 February 20X7:
£’000
Sales: 78,500
Variable costs: (56,520)
Fixed costs: (13,850)
—
Profit before interest 8,130
Debenture interest (1,421)
——
Profit before tax 6,709
Taxation at 17% (1,141)
—
Profit after tax 5,568
Dividends proposed (3,000)
——
Retained profit 2,568
Balance sheet at 28 February 20X7
£’000
Ordinary share capital (£1 shares) £12,500
Retained profits 11,286
——–
23,786
7% debentures (redeemable July 20X9 to December 20Y0) 20,300
——
44,086
The market values of Sentry’s ordinary shares and debentures on 28 February 20X7 are:
Ordinary shares £3.44 (cum-div)
7% debentures £111% (cum int)
The £20 million required would be raised on 1 March 20X7 by either:
1) A rights issue at £2.50 per ordinary share; or
2) An issue of 8% debentures at par, redeemable in 20Y3
You have been asked by the directors to assume the following for the year to 28 February 20X8:
- Sales will increase by 20%
- The contribution to sales ratio will remain unchanged
- Fixed costs will increase by £2 million pa
- The current level of dividends per share will be maintained
- Corporation tax will remain at 17%
For both the rights issue and the debenture issue, prepare forecast income statements for Sentry for the year to 28 February 20X8
For both rights issue and debt issue:
Sales (£78.5m x 1.20) = £94,200m
Variable costs (72% x sales) (67,824m)
Fixed costs (13.85m + £2m) (15.850m)
—–
Profit before interest 10.526m
Rights issue:
Interest:
£20.3m x 7% = (1.421m)
—
PBT: 9.105m
Tax @ 17% (1.548m)
—
Profit after tax 7.557m
Dividends payable (4.920m)
—
Retained earnings 2.637m
Debt issue:
Interest:
£20.3m x 7% = (1.421m)
£20.0m x 8% = (1.600m)
—
(3.021m)
—
PBT: 7.505
Tax @ 17% (1.276m)
—-
Profit after tax 6.229m
Dividends payable (3.000m)
—
Retained earnings = 3.229m
Sentry Underwood Plc (Sentry) is a large, listed UK drinks manufacturer. Sentry’s recent profitability has deteriorated because of increased competition and a volatile consumer market. As a result, Sentry’s board is considering a major change in the company’s trading strategy will cost £20 million to implement. The board has decided that this investment will be funded either via a rights issue or an issue of debentures. Jenna Helier is Sentry’s finance director and she is an ICAEW CA.
Sentry’s other directors have asked her to provide information to help them decide on the source of funding for the new investment.
Extracts below:
Income statement for the year to 28 February 20X7:
£’000
Sales: 78,500
Variable costs: (56,520)
Fixed costs: (13,850)
—
Profit before interest 8,130
Debenture interest (1,421)
——
Profit before tax 6,709
Taxation at 17% (1,141)
—
Profit after tax 5,568
Dividends proposed (3,000)
——
Retained profit 2,568
Balance sheet at 28 February 20X7
£’000
Ordinary share capital (£1 shares) £12,500
Retained profits 11,286
——–
23,786
7% debentures (redeemable July 20X9 to December 20Y0) 20,300
——
44,086
The market values of Sentry’s ordinary shares and debentures on 28 February 20X7 are:
Ordinary shares £3.44 (cum-div)
7% debentures £111% (cum int)
The £20 million required would be raised on 1 March 20X7 by either:
1) A rights issue at £2.50 per ordinary share; or
2) An issue of 8% debentures at par, redeemable in 20Y3
You have been asked by the directors to assume the following for the year to 28 February 20X8:
- Sales will increase by 20%
- The contribution to sales ratio will remain unchanged
- Fixed costs will increase by £2 million pa
- The current level of dividends per share will be maintained
- Corporation tax will remain at 17%
For both the rights issue and the debenture issue, calculate Sentry’s forecast:
- EPS figure for the year to 28 February 20X8; and
- Gearing ratio (book value of long-term borrowings/long-term funds) as at 28 February 20X8
Rights Issue £m
Ordinary share capital (additional 8m shares) = 20.500m
Share premium (8m new shares x £1.50) = 12.000m
Retained earnings 13.923m
—–
46.423m
Debentures = 20.300m
—
Total long-term funds = 66.723m
—
Profit before tax = £7.557m / Shares 20.500m = EPS £0.369
Gearing = Debt £20.3 / Equity £66.723 = 30.4%
Debt issue:
Ordinary share capital = 12.500m
Share premium = 0.000m
Retained earnings 14.515m
—–
27.015m
Debentures = 40.300m
—
Total long-term funds = 67.315m
—
Profit after tax = £6.229m divided by Shares 12.500m = EPS £0.498
Gearing : Debt: £40.300/ Equity £67.315
= 59.9%
Sentry Underwood Plc (Sentry) is a large, listed UK drinks manufacturer. Sentry’s recent profitability has deteriorated because of increased competition and a volatile consumer market. As a result, Sentry’s board is considering a major change in the company’s trading strategy will cost £20 million to implement. The board has decided that this investment will be funded either via a rights issue or an issue of debentures. Jenna Helier is Sentry’s finance director and she is an ICAEW CA.
Sentry’s other directors have asked her to provide information to help them decide on the source of funding for the new investment.
Extracts below:
Income statement for the year to 28 February 20X7:
£’000
Sales: 78,500
Variable costs: (56,520)
Fixed costs: (13,850)
—
Profit before interest 8,130
Debenture interest (1,421)
——
Profit before tax 6,709
Taxation at 17% (1,141)
—
Profit after tax 5,568
Dividends proposed (3,000)
——
Retained profit 2,568
Balance sheet at 28 February 20X7
£’000
Ordinary share capital (£1 shares) £12,500
Retained profits 11,286
——–
23,786
7% debentures (redeemable July 20X9 to December 20Y0) 20,300
——
44,086
The market values of Sentry’s ordinary shares and debentures on 28 February 20X7 are:
Ordinary shares £3.44 (cum-div)
7% debentures £111% (cum int)
The £20 million required would be raised on 1 March 20X7 by either:
1) A rights issue at £2.50 per ordinary share; or
2) An issue of 8% debentures at par, redeemable in 20Y3
You have been asked by the directors to assume the following for the year to 28 February 20X8:
- Sales will increase by 20%
- The contribution to sales ratio will remain unchanged
- Fixed costs will increase by £2 million pa
- The current level of dividends per share will be maintained
- Corporation tax will remain at 17%
For the rights issue only, calculate the increase in annual sales required for the year to 28 February 20X9 in order that Sentry’s EPS figure remains the same as in current year
Current EPS £5.568m/12.500 =
£0.445m
£0.455m x 20.500 =
Target earnings £9.123m
Add back tax (17%) / 83%
Target profit before tax £10.992m
Add back interest 1.421m
Add back fixed costs 15.850m
—
Target contribution £28.263m
Contribution/sales ratio / 28%
–
Target sales = £100.939m
Current sales £78.500m
Target sales/current sales (£100.939m/£78.500m) = 1.286
Thus sales would need to increase by 28.6% or £22,439m
Sentry Underwood Plc (Sentry) is a large, listed UK drinks manufacturer. Sentry’s recent profitability has deteriorated because of increased competition and a volatile consumer market. As a result, Sentry’s board is considering a major change in the company’s trading strategy will cost £20 million to implement. The board has decided that this investment will be funded either via a rights issue or an issue of debentures. Jenna Helier is Sentry’s finance director and she is an ICAEW CA.
Sentry’s other directors have asked her to provide information to help them decide on the source of funding for the new investment.
Extracts below:
Income statement for the year to 28 February 20X7:
£’000
Sales: 78,500
Variable costs: (56,520)
Fixed costs: (13,850)
—
Profit before interest 8,130
Debenture interest (1,421)
——
Profit before tax 6,709
Taxation at 17% (1,141)
—
Profit after tax 5,568
Dividends proposed (3,000)
——
Retained profit 2,568
Balance sheet at 28 February 20X7
£’000
Ordinary share capital (£1 shares) £12,500
Retained profits 11,286
——–
23,786
7% debentures (redeemable July 20X9 to December 20Y0) 20,300
——
44,086
The market values of Sentry’s ordinary shares and debentures on 28 February 20X7 are:
Ordinary shares £3.44 (cum-div)
7% debentures £111% (cum int)
The £20 million required would be raised on 1 March 20X7 by either:
1) A rights issue at £2.50 per ordinary share; or
2) An issue of 8% debentures at par, redeemable in 20Y3
You have been asked by the directors to assume the following for the year to 28 February 20X8:
- Sales will increase by 20%
- The contribution to sales ratio will remain unchanged
- Fixed costs will increase by £2 million pa
- The current level of dividends per share will be maintained
- Corporation tax will remain at 17%
Making reference to your calculations in 43.1, 43.2, 43.3 above, discuss the implications for Sentry’s shareholders of the company using a rights issue or a debenture issue to fund its proposed £20 million investment.
Sentry’s current earnings per share figure is 44.5p. The predicted EPS are 36.9p (rights issue) and 49.8p (debt issue). So the rights issue leads to a lower EPS whilst the debt issue increases EPS and may, for this reason, be favoured by shareholders.
Rights issue:
As would be expected, the level of gearing is much lower than under the debenture issue option (30.4% compared to 59.9%). It’s also lower than Sentry’s current level of gearing (46.0% (£20,300/44.086)).
However if one takes the market value into account then the current gearing figure (34.5%) is much lower. Current…
Other issues to consider:
- The current debentures are due to be repaid in 20X9 - 20Y0. This will create additional financial pressure.
Issue costs - the cost of issuing debentures is likely to be cheaper.
Tax shield - the debenture issue would give Sentry more chance to take advantage
Sentry Underwood Plc (Sentry) is a large, listed UK drinks manufacturer. Sentry’s recent profitability has deteriorated because of increased competition and a volatile consumer market. As a result, Sentry’s board is considering a major change in the company’s trading strategy will cost £20 million to implement. The board has decided that this investment will be funded either via a rights issue or an issue of debentures. Jenna Helier is Sentry’s finance director and she is an ICAEW CA.
Sentry’s other directors have asked her to provide information to help them decide on the source of funding for the new investment.
Extracts below:
Income statement for the year to 28 February 20X7:
£’000
Sales: 78,500
Variable costs: (56,520)
Fixed costs: (13,850)
—
Profit before interest 8,130
Debenture interest (1,421)
——
Profit before tax 6,709
Taxation at 17% (1,141)
—
Profit after tax 5,568
Dividends proposed (3,000)
——
Retained profit 2,568
Balance sheet at 28 February 20X7
£’000
Ordinary share capital (£1 shares) £12,500
Retained profits 11,286
——–
23,786
7% debentures (redeemable July 20X9 to December 20Y0) 20,300
——
44,086
The market values of Sentry’s ordinary shares and debentures on 28 February 20X7 are:
Ordinary shares £3.44 (cum-div)
7% debentures £111% (cum int)
The £20 million required would be raised on 1 March 20X7 by either:
1) A rights issue at £2.50 per ordinary share; or
2) An issue of 8% debentures at par, redeemable in 20Y3
You have been asked by the directors to assume the following for the year to 28 February 20X8:
- Sales will increase by 20%
- The contribution to sales ratio will remain unchanged
- Fixed costs will increase by £2 million pa
- The current level of dividends per share will be maintained
- Corporation tax will remain at 17%
Making reference to your calculations in 43.1, 43.2, 43.3 above, discuss the implications for Sentry’s shareholders of the company using a rights issue or a debenture issue to fund its proposed £20 million investment.
Sentry’s current earnings per share figure is 44.5p. The predicted EPS are 36.9p (rights issue) and 49.8p (debt issue). So the rights issue leads to a lower EPS whilst the debt issue increases EPS and may, for this reason, be favoured by shareholders.
Rights issue:
As would be expected, the level of gearing is much lower than under the debenture issue option (30.4% compared to 59.9%). It’s also lower than Sentry’s current level of gearing (46.0% (£20,300/44.086)).
However if one takes the market value into account then the current gearing figure (34.5%) is much lower. Current…
Other issues to consider:
- The current debentures are due to be repaid in 20X9 - 20Y0. This will create additional financial pressure.
Issue costs - the cost of issuing debentures is likely to be cheaper.
Tax shield - the debenture issue would give Sentry more chance to take advantage
Sentry Underwood Plc (Sentry) is a large, listed UK drinks manufacturer. Sentry’s recent profitability has deteriorated because of increased competition and a volatile consumer market. As a result, Sentry’s board is considering a major change in the company’s trading strategy will cost £20 million to implement. The board has decided that this investment will be funded either via a rights issue or an issue of debentures. Jenna Helier is Sentry’s finance director and she is an ICAEW CA.
Sentry’s other directors have asked her to provide information to help them decide on the source of funding for the new investment.
Extracts below:
Income statement for the year to 28 February 20X7:
£’000
Sales: 78,500
Variable costs: (56,520)
Fixed costs: (13,850)
—
Profit before interest 8,130
Debenture interest (1,421)
——
Profit before tax 6,709
Taxation at 17% (1,141)
—
Profit after tax 5,568
Dividends proposed (3,000)
——
Retained profit 2,568
Balance sheet at 28 February 20X7
£’000
Ordinary share capital (£1 shares) £12,500
Retained profits 11,286
——–
23,786
7% debentures (redeemable July 20X9 to December 20Y0) 20,300
——
44,086
The market values of Sentry’s ordinary shares and debentures on 28 February 20X7 are:
Ordinary shares £3.44 (cum-div)
7% debentures £111% (cum int)
The £20 million required would be raised on 1 March 20X7 by either:
1) A rights issue at £2.50 per ordinary share; or
2) An issue of 8% debentures at par, redeemable in 20Y3
You have been asked by the directors to assume the following for the year to 28 February 20X8:
- Sales will increase by 20%
- The contribution to sales ratio will remain unchanged
- Fixed costs will increase by £2 million pa
- The current level of dividends per share will be maintained
- Corporation tax will remain at 17%
Making reference to your calculations in 43.1, 43.2, 43.3 above, discuss the implications for Sentry’s shareholders of the company using a rights issue or a debenture issue to fund its proposed £20 million investment.
Sentry’s current earnings per share figure is 44.5p. The predicted EPS are 36.9p (rights issue) and 49.8p (debt issue). So the rights issue leads to a lower EPS whilst the debt issue increases EPS and may, for this reason, be favoured by shareholders.
Rights issue:
As would be expected, the level of gearing is much lower than under the debenture issue option (30.4% compared to 59.9%). It’s also lower than Sentry’s current level of gearing (46.0% (£20,300/44.086)).
However if one takes the market value into account then the current gearing figure (34.5%) is much lower. Current…
Other issues to consider:
- The current debentures are due to be repaid in 20X9 - 20Y0. This will create additional financial pressure.
Issue costs - the cost of issuing debentures is likely to be cheaper.
Tax shield - the debenture issue would give Sentry more chance to take advantage of the tax shield and its WACC may fall accordingly, unless the gearing level was then deemed by investors to be too high.
Raising additional funds of £150m
Blackstar has always maintained a policy of no gearing. Other companies in Blackstar’s market sector have an average gearing ratios (measured as debt/equity by market values) of 25%, with a maximum of 35%, and an average interest cover of eight times, with a minimum of six. The finance director of Blackstar is considering raising the £150 million by either a rights issue or by the company now borrowing and issuing debentures.
The details are as follows:
Rights Issue: The £150 million would be raised by a 2 for 3 rights issue, priced at a discount on the current market value of Blackstar’s ordinary shares
Debt Issue: The £150 million would be raised by an issue of 6% coupon debentures, redeemable at par on 20 June 20Y5. The gross redemption yield would be based on the current gross redemption yield of other debentures issued by companies in Blackstar’s market sector. One such company is Blue Plc. Details for Blue’s debentures are as follows:
- Coupon 5%
- The current market price on 30 June 20X8 is £109 cum interest
- Redemption at par on 30 June 20Y3
Further information:
- The forecast pre-tax operating profit for the year ending 30 June 20X8 is £50 million
- The corporation tax rate is 17%
- The current share price at 30 June 20X8 is £7.50 ex-div
- The number of ordinary shares in issue is 60 million
Requirements:
- Assuming a 2 for 3 rights issue is made on 1 July 20X8:
Calculate the discount rights price represents on Blackstar’s current share price
Calculate the TERP per share
Discuss whether the actual share price is likely to be equal to the TERP
Discount =
60/3 x 2 = 40 million new shares
150/40 = 3.75 per share
7.50/3.75 = 50% discount
TERP:
40 x 3.75 = 150m
60 x 7.50 = 450m
Total = 600m
Number of shares = 60 + 40 = 100m
600/100 = £6.00
The share price is unlikely to be equal to the terp as it depends on take-up of the rights issue, market reaction to the expansion and the market condition
