QUESTION 2

1. ABC Ltd. has decided to raise capital via a rights issue. The share price is currently $5.50 and ABC intends to raise $5m. There are currently 6.25m shares in issue and ABC is offering a 1 for 5 rights issue.

Calculate the Ex-Rights Price. (4 marks)

2. BBC Co 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 loan stock at par. Financial information relating to BBC Co is as follows:

Current statement of financial position

$'000 $'000

Non-current assets 6,550

Current assets

Inventory 2,000

Receivables 1,500

Cash 300

3,800

Total assets 10,350

Ordinary shares (par value 50n) 2,000

Reserves 1,500

12% loan notes 2X12 4,500

Current liabilities

Trade payables 1,100

Overdraft 1,250

2,350

Total equity and liabilities 10,350

Other information:

Price/earnings ratio of BBC Co: 15.24

Overdraft interest rate: 7%

Tax rate: 30%

Sector averages: debt/equity ratio (book value): 100%

Interest cover: 6 times

Required

(i) Ignoring issue costs and any use that may be made of the funds raised by the rights issue, calculate:

1. the theoretical ex rights price per share;

2. the value of rights per existing share. (3 marks each)

(ii) What alternative actions are open to the owner of 1,000 shares in BBC Co as regards the rights issue? Determine the effect of each of these actions on the wealth of the investor. (8 marks)

3. The BMX Company is planning to invest $10 million in an expansion program which is expected to increase earnings before interest and taxes by $2.5 million. The company currently is earning $5 per share on 1 million shares of common stock outstanding. The capital structure prior to the investment is:

Debt $10,000,000

Equity $30,000,000

Total $40,000,000

The expansion can be financed by sale of 200,000 shares at $50 net each, or by issuing long-term debt at a 6 percent interest cost. The firms recent profit and loss statement was as follows:

Sales $101,000,000

Variable cost $ 60,000,000

Fixed cost 30,500,000

$ 90,500,000

Earnings before interest and taxes $ 10,500,000

Interest 500,000

Earnings before taxes $10,000,000

Taxes (50%) 5,000,000

Earnings after taxes $ 5,000,000

Assuming the firm maintains its current earnings and achieves the anticipated earnings from the expansion, what will be the earnings per share

(1) if the expansion is financed by debt? (5 marks)

(2) if the expansion is financed by equity? (5 marks)

(Total: 36 marks)