6. Rights Issues Long term Financing Santa PLC is an all equity financed company with 100 million shares outstanding trading at 2 per share. Its management has decided to invest in a major new development that will cost 40 million, and is now considering ways to finance the investment. Various alternatives have been considered but the choice has been narrowed down to a rights issue or the issue of debentures (a kind of bond). The rights issue would be made at a discount of 20% and be underwritten at a cost of 2% of the proceeds. The companys chairman has discussed the proposed investment and its prospects as well as the financing possibilities, quite openly with various institutions and the financial press. As a result it is likely that the share price already reflects the implications of the companys proposed investment. Required : a) Determine the terms of the right issue, the ex-rights price and the theoretical value of the right. (5 marks) b) Demonstrate that in principle the shareholders will be equally well off by subscribing to the issue or by selling their rights. Assume the shareholder has 100 shares. (3 marks) c) Explain the impact on the value of the right if the issue is undertaken on the specified terms and the share (cum-rights) price falls to 1.8 shortly after the shareholders are invited to subscribe to the new issue. (2 marks) d) Would a deep discount without underwriting be preferable to save the expense of the underwriting fees ? Management considered the possibility but decided against it as it would have resulted in the dilution of EPS. Comment on the view taken by the management. (3 marks) e) Evaluate the contention that the shareholders can expect an earnings yield of 30% on shares bought given a rights issue at a discount of 20%, and that this suggests a relatively high cost of capital. (2 marks) f) The cost of underwriting is sometimes assessed in terms of the costs of an equivalent PUT option. Explain and discuss this approach. (3 marks) g) Explain and assess the view that rights issues are designed to protect the interests of shareholders. (2 marks) (TOTAL 20 MARKS)