Chapter 12 Sources of Finance
1. Objectives
1.1 Identify and discuss the range of short-term sources of finance available to businesses, including:
(a) Overdraft
(b) Short-term loan
(c) Trade credit
(d) Lease finance
1.2 Identify and discuss the range of long-term sources of finance available to businesses, including:
(a) Equity finance
(b) Debt finance
(c) Venture capital
1.3 Identify and discuss methods of raising equity finance, including:
(a) Rights issue
(b) Placing
(c) Public offer
(d) Stock exchange listing
2. Short-term Sources of Finance
2.1 Short-term finance is usually needed for businesses to run their day-to-day operations including payment of wages to employees, inventory ordering and supplies. Businesses with seasonal peaks and troughs and those engaged in international trade are likely to be heavy users of short-term finance.
2.2 Overdrafts
2.2.1 Overdrafts are one of the most important sources of short-term finance available to businesses. They can be arranged relatively quickly, and offer a level of flexibility with regard to the amount borrowed at any time, whilst interest is only paid when the account is overdrawn.
2.2.2 By providing an overdraft facility to a customer, the bank is committing itself to provide an overdraft to the customer whenever the customer wants it, up to the agreed limit. The bank will earn interest on the lending, but only to the extent that the customer uses the facility and goes into overdraft. If the customer does not go into overdraft, the bank cannot charge interest.
2.2.3 The bank will generally charge a commitment fee when a customer is granted an overdraft facility or an increase in his overdraft facility. This is a fee for granting an overdraft facility and agreeing to provide the customer with funds if and whenever he needs them.
2.2.4 |
Example 1 |
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Many businesses require their bank to provide financial assistance for normal trading over the operating cycle. For example, suppose that a business has the following operating cycle.
It now buys inventory costing $2,500 for cash, using its overdraft. Working capital remains the same, $6,000, although the bank’s financial stake has risen from $1,000 to $3,500.
A bank overdraft provides support for normal trading finance. In this example, finance for normal trading rises from $(10,000 – 3,000) = $7,000 to $(12,500 – 3,000) = $9,500 and the bank’s contribution rises from $1,000 out of $7,000 to $3,500 out of $9,500. |
2.2.5 When a business customer has an overdraft facility, and the account is always in overdraft, then it has a solid core (or hard core) overdraft. If the hard core element of the overdraft appears to be becoming a long-term feature of the business, the bank might wish, after discussions with the customer, to convert the hard core of the overdraft into a loan, thus giving formal recognition to its more permanent nature. Otherwise annual reductions in the hard core of an overdraft would typically be a requirement of the bank.
2.2.6 Advantages and disadvantages of overdrafts
Advantages |
Disadvantages |
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2.3 Short-term loans
2.3.1 A term loan is a loan for a fixed amount for a specified period. It is drawn in full at the beginning of the loan period and repaid at a specified time or in defined instalments. Term loans are offered with a variety of repayment schedules. Often, the interest and capital repayments are predetermined.
2.3.2 Advantages for the borrower
(a) The borrower knows what he will be expected to pay back at regular intervals and the bank can also predict its future income with more certainty.
(b) Once the loan is agreed, the term of the loan must be adhered to, provided that the customer does not fall behind with his payments. It is not repayable on demand by the bank.
2.4 Trade credit
2.4.1 Trade credit is one of the main sources of short-term finance for a business. Current assets such as raw materials may be purchased on credit with payment terms normally varying from between 30 to 90 days. Trade credit therefore represents an interest free short-term loan.
2.4.2 In a period of high inflation, purchasing via trade credit will be very helpful in keeping costs down. However, it is important to take into account the loss of discounts suppliers offer for early payment.
2.4.3 Unacceptable delays in payment will worsen a company’s credit rating and additional credit may become difficult to obtain.
2.5 Leasing
2.5.1 Rather than buying an asset outright, using either available cash resources or borrowed funds, a business may lease an asset. Leasing has become a popular source of finance.
2.5.2 Leasing can be defined as a contract between lessor and lessee for hire of a specific asset selected from a manufacturer or vendor of such assets by the lessee. The lessor retains ownership of the asset. The lessee has possession and use of the asset on payment of specified rentals over a period.
3. Debt Finance
3.1 A range of long-term sources of finance are available to businesses including debt finance, leasing, venture capital and equity finance.
3.2 Long-term finance is used for major investments and is usually more expensive and less flexible than short-term finance.
3.3 Reasons for seeking debt finance
(Jun 10, Dec 10)
3.3.1 Sometimes businesses may need long-term funds, but may not wish to issue equity capital.
(a) Perhaps the current shareholders will be unwilling to contribute additional capital.
(b) Possibly the company does not wish to involve outside shareholders who will have more onerous requirements than current members;
(c) May include lesser cost and easier availability, particularly if the company has little or no existing debt finance.
(d) Debt finance provides tax relief on interest payments.
3.4 Factors influencing choice of debt finance
(Jun 08, Jun 12)
3.4.1 The choice of debt finance that a company can make depends upon:
(a) Availability – Only listed companies will be able to make a public issue of loan notes on a stock exchange; smaller companies may only be able to obtain significant amounts of debt finance from their bank.
(b) Duration – If loan finance is sought to buy a particular asset to generate revenues for the business, the length of the loan should match the length of time that the asset will be generating revenues.
(c) Fixed or floating rate – Expectations of interest rate movements will determine whether a company chooses to borrow at a fixed or floating rate. Fixed rate finance may be more expensive, but the business runs the risk of adverse upward rate movements if it chooses floating rate finance.
(d) Security and covenants – The choice of finance may be determined by the assets that the business is willing or able to offer as security, also on the restrictions in covenants that the lenders wish to impose.
(e) Gearing and financial risk – If already too high, not suitable to raise debt finance.
(f) Target capital structure – A company should seek to minimize its WACC. In practical terms this can be achieved by having some debt in its capital structure, since debt is relatively cheaper than equity.
(g) Economic expectations – It is more easy to borrow money from bank in good economic conditions.
3.5 Loan notes
(Jun 13)
3.5.1 The term bonds describes various forms of long-term debt a company may issue, such as loan notes or debentures, which may be:
(a) Redeemable
(b) Irredeemable
3.5.2 Bonds or loans come in various forms, including:
(a) Floating rate debentures
(b) Zero coupon bonds
(c) Convertible loan stock
3.5.3 Loan notes are also known as corporate bonds or loan stock:
(a) traded on stock markets in much the same way as shares
(b) may be secured or unsecured
(c) secured debt will take the form of either a fixed charge or a floating charge.
Fixed charge |
Floating charge |
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3.5.4 Advantages and disadvantages
Advantages |
Disadvantages |
From the view point of investors:
From the view point of company:
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From the viewpoint of investors:
From the view point of company:
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3.6 Zero coupon bonds
3.6.1 Zero coupon bonds are bonds that are issued at a discount to their redemption value, but no interest is paid on them.
3.6.2 The advantage for borrowers (i.e. the company) is that zero coupon bonds can be used to raise cash immediately, and there is no cash repayment until redemption date. The cost of redemption is known at the time of issue. The borrower can plan to have funds available to redeem the bonds at maturity.
3.6.3 The advantage for lenders is restricted, unless the rate of discount on the bonds offers a high yield. The only way of obtaining cash from the bonds before maturity is to sell them. Their market value will depend on the remaining term to maturity and current market interest rates.
3.7 Deep discount bonds
3.7.1 Deep discount bonds are loan notes issued at a price which is at a large discount to the nominal value of the notes, and which will be redeemable at par or above par when they eventually mature.
3.7.2 |
Example 2 |
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A company issue $1,000,000 of loan notes in 2010, at a price of $50 per $100 of note, and redeemable at par in the year 2019. For a company with specific cash flow requirements, the low servicing costs during the currency of the bond may be an attraction, coupled with a high cost of redemption at a maturity. |
3.8 Convertible loan notes
3.8.1 Convertible loan notes are bonds that give the holder the right to convert to other securities, normally ordinary shares, at a pre-determined price/rate and time.
(a) Conversion value and conversion premium
3.8.2 The current market value of ordinary shares into which a loan note may be converted is known as the conversion value. The conversion value will be below the value of the note at the date of issue, but will be expected to increase as the date for conversion approaches on the assumption that a company’s shares ought to increase in market value over time.
Conversion premium = Issue value of note – conversion value of note
3.8.3 |
Example 3 |
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The 10% convertible loan notes of XYZ Co are quoted at $142 per $100 nominal. The earliest date for conversion is in four years time, at the rate of 30 ordinary shares per $100 nominal loan note. The share price is currently at $4.15. Annual interest on the notes has just been paid. Required: (a) What is the average annual growth rate in the share price that is required for the bondholders to achieve an overall rate of return of 12% a year compound over the next four years, including the proceeds of conversion? Solution: (a)
The value of 30 shares on conversion at the end of year 4 must have a present value of at least $111.62, to provide investors with a 12% return. The money value at the end of year 4 needs to be $111.62 ÷ 0.636 = $175.50. The current market value of 30 shares is (× $4.15) $124.50. The growth factor in the share price over four years needs to be: If the annual rate of growth in the share price, expressed as a proportion, is g, then: Conclusion: The rate of growth in the share price needs to be 9% a year (compound). (b) (i) As an amount per share |
(b) The issue price and the market price of convertible loan notes
3.8.4 A company will aim to issue loan notes with the greatest possible conversion premium as this will mean that, for the amount of capital raised, it will, on conversion, have to issue the lowest number of new ordinary shares. The premium that will be accepted by potential investors will depend on the company’s growth potential and so on prospects for a sizeable increase in the share price.
3.8.5 Convertible loan notes issued at par normally have a lower coupon rate of interest than straight debt. This lower yield is the price the investor has to pay for the conversion rights. It is, of course, also one of the reasons why the issue of convertible notes is attractive to a company.
3.8.6 The actual market price of convertible notes will depend on:
(a) the price of straight debt
(b) the current conversion value
(c) the length of time before conversion may take place
(d) the market’s expectation as to future equity returns and the risk associated with these returns
3.8.7 |
Test your understanding 1 |
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ABC has issued 50,000 units of convertible loan notes, each with a nominal value of $100 and a coupon rate of interest of 10% payable yearly. Each $100 of convertible loan notes may be converted into 40 ordinary shares of ABC in three years time. Any notes not converted will be redeemed at $110 (that is, at $110 per $100 nominal value of note). Estimate the likely current market price for $100 of the loan notes, if investors in the loan notes now require a pre-tax return of only 8%, and the expected value of ABC ordinary shares on the conversion day is: (a) $2.50 per share |
4. Venture Capital (風險投資)
(Jun 13)
4.1 Venture capital is the provision of risk bearing capital, usually in the form of a participation in equity, to companies with high growth potential.
4.2 Venture capitalists provide start-up and late stage growth finance, usually for smaller firms.
4.3 For most venture funds, evaluating financial information comes second to evaluating the credibility of the firm’s management. A view must be formed as to whether the existing team has sufficient expertise to manage a growing firm, or whether specialist talent needs to be added.
4.4 The investor would then wish to see evidence that thorough studies of the firm’s markets had been made, so that projected sales budgets were realistic. The single most common cause of failure in this sort of situation is over-optimism in sales projections. Relevant information includes market research, orders in hand, letters from potential customers and general projections of the market’s prospects.
4.5 The investor would also be interested in knowing how much influence it is envisaged it will have on the management decision making in the firm. Nearly all venture funds will want a seat on the board. Their aim is to provide advice and be able to influence management rather than to participate in the day-to-day running of the company.
4.6 Typically venture capitalists will provide finance in return for 20-49.9% of a company’s shares. This allows them to exert control without becoming majority shareholders.
4.7 The venture capitalists may seek to exit (liquidate their investment) via a trade sale, flotation, redemption of preference shares at a premium or a buy-back of their shares on re-financing.
5. Equity Finance
5.1 There are three main sources of equity finance:
(a) internally-generated funds – retained earnings
(b) rights issue
(c) new external share issues – placings, offers for sale, etc.
5.2 Internally-generated funds
5.2.1 Internally-generated funds comprise:
(a) retained earnings plus
(b) non-cash charges against profits (e.g. depreciation).
5.2.2 For an established company, internally-generated funds can represent the single most important source of finance, for both short and long-term purposes.
5.3 New external share issues
5.3.1 An unquoted company can obtain a listing on the stock market by means of a:
(a) Initial public offer (IPO)
(b) Placing
(c) Introduction
(a) Initial public offer
5.3.2 An initial public offer is an invitation to apply for shares in a company based on information contained in a prospectus.
5.3.3 An IPO is a means of selling the shares of a company to the public at large. When companies go public for the first time, a large issue will probably take the form of an IPO. Subsequent issues are likely to be placings or rights issues, described later.
5.3.4 An IPO entails the acquisition by an issuing house (發行人) of a large block of shares of a company, with a view to offering them for sale to the public and investing institutions.
5.3.5 An issuing house is usually a merchant bank. It may acquire the shares either as a direct allotment from the company or by purchase from existing members. In either case, the issuing house publishes an invitation to the public to apply for shares, either at a fixed price or on a tender basis. The issuing house accepts responsibility to the public, and gives to the issue the support of its own standing.
5.3.6 Cost of share issues on the stock market
(a) Underwriting costs
(b) Stock market listing fee (the initial charge) for the new securities
(c) Fess of the issuing house, solicitors, auditors and public relations consultant
(d) Charges for printing and distributing the prospectus
(e) Advertising in national newspapers
(b) Placing (配售)
(Jun 09, Jun 13)
5.3.7 A placing is an arrangement whereby the shares are not all offered to the public, but instead, the sponsoring market maker arranges for most of the issue to be bought by a smaller number of investors, usually institutional investors such as pension funds and insurance companies.
5.3.8 The choice between an IPO and placing
(a) Placings are much cheaper. Approaching institutional investors privately is a much cheaper way of obtaining finance, and thus placings are often used for smaller issues.
(b) Placings are likely to be quicker.
(c) Placings are likely to involve less disclosure of information.
(d) However, most of the shares will be placed with a relatively smaller number of (institutional) shareholders, which means that most of the shares are unlikely to be available for trading after the flotation, and that institutional shareholders will have control of the company.
(e) When a company first comes to the market in the UK, the maximum proportion of shares that can be placed is 75%, to ensure some shares are available to a wider public.
(c) Introduction
5.3.9 Introduction is a process that allows a company to join a stock exchange without raising capital. A company does not issue any fresh shares; it merely introduces its existing shares in the market.
5.3.10 It is used where the public already holds at least 25% of the shares in the company (the minimum requirement for a stock exchange listing). The shares become listed and members of the public can buy shares from the existing shareholders.
5.4 Rights issue
(Dec 07, Jun 08, Dec 08, Jun 09, Dec 09, Jun 11, Dec 11)
5.4.1 A rights issue is an offer to existing shareholders enabling them to buy more shares, usually at a price lower than the current market price.
5.4.2 Major advantages of a rights issue:
(a) Rights issue are cheaper than IPOs to the general public. This is partly because no prospectus is not normally required, partly because the administration is simpler and partly because the cost of underwriting will be less.
(b) Rights issues are more beneficial to existing shareholders than issues to the general public. New shares are issued at a discount to the current market price, to make them attractive to investors. A rights issue secures the discount on the market price for existing shareholders, who may either keep the shares or sell them if they wish.
(c) Relative voting rights are unaffected if shareholders all take up their rights.
(d) The finance raised may be used to reduce gearing in book value terms by increasing share capital and/or to pay off long-term debt which will reduce gearing in market value terms.
(a) Deciding the issue price for a rights issue
5.4.3 The offer price in a rights issue will be lower than the current market price of existing shares. The size of the discount will vary, and will be larger for difficult issues. The offer price must however be at or above the nominal value of the shares, so as not to contravene company law.
5.4.4 A company making a rights issue must set a price which is lower enough to secure the acceptance of shareholders, who are being asked to provide extra funds, but not too low, so as to avoid excessive dilution of the EPS.
5.4.5 |
Example 4 |
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A company can achieve a profit after tax of 20% on the capital employed. At present its capital structure is as follows.
The directors propose to raise an additional $126,000 from a rights issue. The current market price is $1.80. Required: (a) Calculate the number of shares that must be issued if the rights price is: $1.60; $1.50; $1.40; $1.20. Solution: The earnings at present are 20% of $300,000 = $60,000. This gives EPS of 30c. The earnings after the rights issue will be 20% of $426,000 = $85,200.
Note that at a high rights price the EPS are increased, not diluted. The breakeven point (zero dilution) occurs when the rights price is equal to the capital employed per share: $300,000 ÷ 200,000 = $1.50. |
(b) Theoretical ex rights price
5.4.6 When a rights issue is announced, all existing shareholders have the right to subscribe for new shares, and so there are rights attached to the existing shares. The shares are therefore described as being cum rights (with rights attached) and are traded cum rights. On the first day of dealings in the newly issued shares, the rights no longer exist and the old shares are now ex rights (without rights attached).
5.4.7 After the announcement of a rights issue, share prices normally fall. The extent and duration of the fall may depend on the number of shareholders and the size of their holdings. This temporary fall is due to uncertainty in the market about the consequences of the issue, with respect to future profits, earnings and dividends.
5.4.8 In theory, the new market price will be the consequence of an adjustment to allow for the discount price of the new issue, and a theoretical ex rights price can be calculated.
5.4.9 |
Example 5 |
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ABC has 1,000,000 ordinary shares of $1 in issue, which have a market price on 1 September of $2.10 per share. The company decides to make a rights issue, and offers its shareholders the right to subscribe for one new share at $1.50 each for every four shares already held. After the announcement of the issue, the share price fell to $1.95, but by the time just prior to the issue being made, it had recovered to $2 per share. The market value just before the issue is known as the cum rights price. What is the theoretical ex rights price? Solution: Value of the portfolio for a shareholder with 4 shares before the rights issue:
So the theoretical ex rights price = $9.50 ÷ 5 = $1.90 The value of rights is the theoretical gain a shareholder would make by exercising his rights. If he does not have enough money to buy the share himself, he would sell the right to subscribe for a new share to another investor, and receive $0.40 from the sale. This other investor would then buy the new share for $1.50, so that his total outlay to acquire the share would be $0.40 + $1.50 = $1.90, the theoretical ex rights price. |
(c) Actions to shareholders for rights issue
5.4.10 The possible courses of actions open to shareholders are:
(a) To take up or exercise the rights, that is, to buy the new shares at the rights price. Shareholders who do this will maintain their percentage holdings in the company by subscribing for the new shares.
(b) To renounce the rights and sell them on the market. Shareholders who do this will have lower percentage holdings of the company’s equity after the issue than before the issue, and the total value of their shares will be less.
(c) To renounce part of the rights and take up the remainder. For example, a shareholder may sell enough of his rights to enable him to buy the remaining rights shares he is entitled to with the sale proceeds, and so keep the total market value of his shareholding in the company unchanged.
(d) To do nothing. Shareholders may be protected from the consequences of their inaction because rights not taken up are sold on a shareholder’s behalf by the company. The Stock Exchange rules state that if new securities are not taken up, they should be sold by the company to new subscribers for the benefit of the shareholders who were entitled to the rights.
5.4.11 |
Example 6 |
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A company has issued 3,000,000 ordinary shares of $1 each, which are at present selling for $4 per share. The company plans to issue rights to purchase one new equity share at a price of $3.20 per share for every three shares held. A shareholder who owns 900 shares thinks that he will suffer a loss in his personal wealth because the new shares are being offered at a price lower than market value. On the assumption that the actual market value of shares will be equal to the theoretical ex rights price, what would be the effect on the shareholder’s wealth if: Solution: The theoretical ex rights price:
So the theoretical ex rights price = $15.20 ÷ 4 = $3.80
The value of the rights attached to each existing share is $0.60 ÷ 3 = $0.20. We will assume that a shareholder is able to sell his rights for $0.20 per existing share held. (a) If the shareholder sells all his rights:
Total value of 900 shares cum rights = 900 x $4 = $3,600. (b) If the shareholder exercises half of the rights (buys 450/3 = 150 shares at $3.20) and sells the other half:
The shareholder would neither gain nor loss wealth, although he will have increased his investment in the company by $480. (c) If the shareholder does nothing, but all other shareholders either exercise their rights or sell them, he would lose wealth as follows.
It follows that the shareholder, to protect his existing investment, should either exercise his rights or sell them to another investor. If he does not exercise his rights, the new securities he was entitled to subscribe for might be sold for his benefit by the company, and this would protect him from losing wealth. |
(d) The actual market price after a rights issue
5.4.12 The actual market price of a share after a rights issue may differ from the theoretical ex rights price. This will occur when the expected yield from new funds raised does not equal earnings yield from existing funds.
5.4.13 The market will take a view of how profitably the new funds will be invested, and will value the shares accordingly.
5.4.14 |
Example 7 |
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A company currently has 4,000,000 ordinary shares in issue, valued at $2 each, and the company has annual earnings equal to 20% of the market value of the shares. A one for four rights issue is proposed, at an issue price of $1.50. If the market continues to value the shares on a price/earnings ratio of 5, what would be the value per share if the new funds are expected to earn, as a percentage of the money raised: Solution: The theoretical ex rights price will be calculated first.
Theoretical ex rights price = $9.5/5 = $1.90
If the market values shares on a P/E ratio of 5, the total market value of equity and the market price per share would be as follows.
(a) If the additional funds raised are expected to generate earnings at the same rate as existing funds, the actual market value will probably be the same as the theoretical ex rights price. The decision by individual shareholders as to whether they take up the offer will therefore depend on:
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Examination Style Questions
Question 1 – Rights Issue
The statement of financial position of Hameldown plc, a telecommunications business, revealed the following long-term capital structure as at 30 November 2006:
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£m |
Ordinary share 50p fully paid |
80.0 |
Share premium account |
30.0 |
Retained profit |
135.0 |
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245.0 |
The company is listed on the London Stock Exchange and the current share price is £4·20.
The company recently repaid all of its long-term loan capital.
The company has decided to invest heavily in new technology and, as a result, has identified an immediate long-term financing requirement of £48 million. To raise the necessary funds, the directors of the company are considering two possible options. The first is to make a one-for-eight rights issue at a discount price of £2·40 per share. The second option is to take out a long-term debenture at an interest rate of 7·5% per year. If the share option is selected, it is expected that the price earnings (P/E) ratio will fall by 5% and if the debenture option is selected, it is estimated that the P/E ratio will rise by 6% by the end of the year to 30 November 2007.
In the year to 30 November 2006, the net profit before interest and taxation for the company was £60 million and it is expected that this will increase by £15 million during the forthcoming year. The company intends to make no dividend payments during the year.
Assume a corporation tax rate of 20%.
Required:
(a) Assuming a rights issue of shares is made, calculate
(i) the theoretical ex-rights price of an ordinary share in Hameldown plc, and
(ii) the value of the rights for each original ordinary share. (5 marks)
(b) Estimate the price of an ordinary share in Hameldown plc on 30 November 2007 assuming:
(i) a rights issue is made;
(ii) a debenture issue is made.
and discuss your findings (12 marks)
(c) Explain, from the company’s viewpoint, how critical the pricing of a rights issue is likely to be. (3 marks)
(Total 20 marks)
A well-functioning stock exchange is an essential requirement of a well-functioning private enterprise system.
Required:
(a) Briefly explain the nature and purpose of a stock exchange. (4 marks)
(b) Discuss the possible advantages and disadvantages for a company of obtaining a listing on a stock exchange. (16 marks)
(Total 20 marks)
Venture capital is an important source of capital for some businesses.
Required:
(a) Explain what is meant by the term ‘venture capital’ and identify the main types of business ventures that are likely to be an attractive investment for a venture capitalist. (7 marks)
(b) Outline the main issues that the board of directors of a company should take into account when considering the use of venture capital finance. (4 marks)
(c) Discuss the main factors that a venture capitalist will consider when assessing an investment proposal. (9 marks)
(Total 20 marks)
Question 4 – Rights Issue
Sagitta plc is a large UK fashion retailer that opened stores in India and China three years ago. This has proved to be less successful than expected and so the directors of the company have decided to withdraw from the overseas market and to concentrate on the UK market. To raise the finance necessary to close the overseas stores, the directors have also decided to make a one-for-five rights issue at a discount of 30% on the current market value. The most recent profit and loss account of the business is as follows:
The shares of the business are currently traded on the London Stock Exchange at a P/E ratio of 16 times. An investor owning 10,000 ordinary shares in the business, has received information of the forthcoming rights issue but cannot decide whether to take up the rights issue, sell the rights, or allow the rights offer to lapse.
Required:
(a) Calculate the theoretical ex-rights price of an ordinary share in Sagitta plc.
(5 marks)
(b) Calculate the price at which the rights in Sagitta plc are likely to be traded.
(3 marks)
(c) Evaluate each of the options available to the investor with 10,000 ordinary shares. (8 marks)
(d) State, from the viewpoint of the business, how critical the pricing of a rights issue is likely to be. (4 marks)
(Total 20 marks)
Question 5 – Rights Issue and Other Equity Financing
XTA Co is an all equity financed, listed company which operates in the food processing industry. The XTA Co family owns 40% of the ordinary shares; the remainder are held by large financial institutions. There are 10 million $1 ordinary shares currently in issue.
The company has just finalized a long-term contract to supply a large chain of restaurants with a variety of food products. The contract requires investment in new machinery costing $24 million. This machinery would become operational on 1 January 2008, and payment would be made on the same date. Sales would commence immediately thereafter.
Company policy is to pay out all profits as dividends and, if XTA Co continues to be all equity financed, there will be an annual dividend of $9 million in perpetuity commencing 31 December 2008.
There are two alternatives that are going to be considered at the next board meeting to finance the required investment of $24 million.
(1) A 2-for-5 rights issue, in which case the annual dividend would be $9 million. The cum rights price per share would be $6.60.
(2) Issuing 7.5% irredeemable debt at par with interest payable annually in arrears. For this alternative, interest would be paid out of the $9 million otherwise available to pay dividends.
For either alternative, the directors expect the cost of equity to remain a its present annual level of 10%.
One of the directors has been wondering whether the board ought to be considering further options – raising equity finance by means of a placing, a public offer for sale or subscription, or raising unsecured loan finance with warrants attached.
Required:
(a) Calculate the issue and ex rights share prices of XTA Co assuming a 2-for-5 rights issue is used to finance the new project at 1 January 2008. Ignore taxation. (4 marks)
(b) Calculate the profit available for dividend at 31 December 2008 if 7.5% irredeemable debt is issued to finance the new project. Assume that the cost equity remains at 10% each year. Ignore taxation. (2 marks)
(c) Write a report to the directors of XTA Co which:
(i) Compares and contrasts the right issue and the debt issue methods of raising finance – you may refer to the calculations in your answer to requirements (a) and (b) and to any assumptions made.
(ii) Explains and evaluates the appropriateness of the following alternative methods of issuing equity finance in the specific circumstances of XTA Co:
(1) A placing
(2) An offer for sale
(3) A public offer for subscription
(iii) Explains and evaluates the appropriateness of issuing unsecured loan stock with warrants attached in the specific circumstances of XTA Co.
(19 marks)
(Total 25 marks)
Question 6 – Rights Issue
Tirwen plc is a medium-sized manufacturing company which is considering a 1 for 5 rights issue at a 15% discount to the current market price of £4·00 per share. Issue costs are expected to be £220,000 and these costs will be paid out of the funds raised. It is proposed that the rights issue funds raised will be used to redeem some of the existing debentures at par. Financial information relating to Tirwen plc is as follows:
Required:
(a) Ignoring issue costs and any use that may be made of the funds raised by the rights issue, calculate:
(i) the theoretical ex rights price per share;
(ii) the value of rights per existing share. (3 marks)
(b) What alternative actions are open to the owner of 1,000 shares in Tirwen plc as regards the rights issue? Determine the effect of each of these actions on the wealth of the investor. (6 marks)
(c) Calculate the current earnings per share and the revised earnings per share if the rights issue funds are used to redeem some of the existing debentures. (6 marks)
(d) Evaluate whether the proposal to redeem some of the debentures would increase the wealth of the shareholders of Tirwen plc. Assume that the price/earnings ratio of Tirwen plc remains constant. (3 marks)
(e) Discuss the reasons why a rights issue could be an attractive source of finance for Tirwen plc. Your discussion should include an evaluation of the effect of the rights issue on the debt/equity ratio and interest cover. (7 marks)
(Total 25 marks)
(ACCA 2.4 Financial Management and Control December 2004 Q3)
Question 7 – Dividend Policy, Gearing, Rights Issue and Operating Lease
The following financial information relates to Echo Co:
Income statement information for the last year
|
$m |
Profit before interest and tax |
12 |
Interest |
3 |
Profit before tax |
9 |
Income tax expense |
3 |
Profit for the period |
6 |
Dividends |
2 |
Retained profit for the year |
4 |
Statement of financial position information as at the end of the last year
|
$m |
$m |
Ordinary shares, par value 50c |
5 |
|
Retained earnings |
15 |
|
Total equity |
|
20 |
8% loan notes, redeemable in three years’ time |
|
30 |
|
|
50 |
Average data on companies similar to Echo Co:
Interest coverage ratio 8 times
Long-term debt/equity (book value basis) 80%
The board of Echo Co is considering several proposals that have been made by its finance director. Each proposal is independent of any other proposal.
Proposal A
The current dividend per share should be increased by 20% in order to make the company more attractive to equity investors.
Proposal B
A bond issue should be made in order to raise $15 million of new debt capital. Although there are no investment opportunities currently available, the cash raised would be invested on a short-term basis until a suitable investment opportunity arose. The loan notes would pay interest at a rate of 10% per year and be redeemable in eight years’ time at par.
Proposal C
A 1 for 4 rights issue should be made at a 20% discount to the current share price of $2·30 per share in order to reduce gearing and the financial risk of the company.
Required:
(a) Analyse and discuss Proposal A. (5 marks)
(b) Evaluate and discuss Proposal B. (7 marks)
(c) Calculate the theoretical ex rights price per share and the amount of finance that would be raised under Proposal C. Evaluate and discuss the proposal to use these funds to reduce gearing and financial risk. (7 marks)
(d) Discuss the attractions of operating leasing as a source of finance. (6 marks)
(Total 25 marks)
(ACCA F9 Financial Management December 2007 Q3)
Source: https://hkiaatevening.yolasite.com/resources/HKSCFMNotes/Chapter12-SourcesofFinance.doc
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