Arthur Graham plc (AG) is a Stock Exchange listed business that owns a chain of builders’ merchants throughout the south of England. AG is currently financed principally by equity, as a result of organic growth.

An opportunity has arisen for AG to purchase all of the shares of an unlisted business, Sandboy Ltd, which owns a chain of builders’ merchants with branches in many locations in the Midlands, an area into which AG’s directors wish to expand. The price being asked by the shareholders equals about 25 per cent of AG’s market capitalisation. Given the price and the prospects for Sandboy, the directors of AG are keen to acquire the shares.

The scale of the investment is such that AG could not raise the cash from internal sources and will have to make a rights issue of ordinary shares, an issue of preference shares or a loan notes issue. A decision now needs to be made on the method of funding.

Three of the directors have spoken to you about the funding decision and their comments have included the following:

● Director A: ‘I’m not keen on borrowing because the interest will inevitably reduce our earnings per share and, therefore, our share price.’

● Director B: ‘I don’t favour a rights issue because inevitably many of our shareholders don’t want to increase their investment and will lose out as a result. Irrespective of the direct effects of a rights issue on our share price, this will have an adverse effect on the total market value of our company. An issue of loan notes seems the best idea.’

● Director C: ‘I favour a preference share issue, because it would be neutral as far as the capital gearing question is concerned; it will neither increase it nor reduce it.’

A board meeting has been arranged at which a final decision on the acquisition of Sandboy and, most importantly, the means of funding it will be discussed. As finance director, you have been asked to provide a briefing note for the directors to read in preparation for this meeting. Your briefing note should cover all relevant points about the funding arrangements and the points raised by the directors. The briefing note must be in simple, non-technical language. All of the relevant factors must be clearly explained and placed in the context of the particular circumstances of the question.

Prepare the briefing note requested by the directors.