Maltby plc, a company quoted on the London Stock Exchange, has been making regular annual after-tax profits of £7 million for some years and has the following long-term capital structure.

The bond issue is not due to be redeemed for some time and the company has become increasingly concerned about the need to continue paying interest at 12 per cent when the interest rate on newly issued government stock of a similar maturity is only 6 per cent.

A proposal has been made to issue 2 million new shares in a rights issue, at a discount of 20 per cent to the current share price of Maltby plc, and to use the funds raised to pay off part of the bond issue. The current share price of Maltby plc is

£3.50 and the current market price of the bonds is £112 per £100 bond.

Alternatively, the funds raised by the rights issue could be invested in a new project giving an annual after-tax return of 20 per cent. Whichever option is undertaken, the stock market view of the company’s prospects and hence its price/earnings ratio will remain unchanged. Maltby plc pays corporation tax at a rate of 30 per cent.

By considering the effect on the share price of the two alternative proposals, discuss whether the proposed rights issue can be recommended as being in the best interests of the ordinary shareholders of Maltby plc. Your answer should include all relevant calculations.

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Ordinary shares, 50p each 12 per cent bonds 000 4 000 9 000 13 000