RH plc manufactures machine tools. It has issued two million ordinary shares, quoted at 168 pence each, and £1 million 10 per cent secured debentures quoted at par. To finance expansion, the directors of the company want to raise £1 million for additional working capital.

Cash flow from trading before interest and tax is currently £1 million per annum. It is expected to rise to £1.3 million per annum if the expansion programme goes ahead. To simplify placing a valuation on the company's equity, you should assume that:

• The forecast level of cash flow, and a tax rate of 33 per cent, will continue indefinitely.

• The required rate of return on the market value of equity, 18 per cent post-tax, will be unaffected by the new financing.

• There is no difference between taxable profits and cash flow.

The company's directors are considering two forms of finance - equity via a rights issue at 15 per cent discount to current share price, or 12 per cent unsecured loan stock at par.

Required

(a) Calculate for both financing options, the expected

(i) Increase in the market value of equity

(ii) Debt/(debt + equity) ratio

(iii) Weighted average cost of capital.

(b) Assume you are the financial manager for RH plc. Write a brief report to the board advising which of the two types of financing is to be preferred. Include in your report brief comments on non-financial factors which should be considered by the directors before deciding how to raise the £1 million finance.