uestion $4$

Everitt Co is planning an expansion of its business operations which will increase profit before interest

and tax by $20\%.$ The company is considering whether to use equity or debt finance to raise the $$2$

million needed by the business expansion.

If equity finance is used, a $1$ for $5$ rights issue will be offered to existing shareholders at a $20\%$ discount

to the current ex dividend share price of $$5\mathrm{.}00$ per share. The nominal value of the ordinary shares is

$$1\mathrm{.}00$ per share. If debt finance is used, Tin Co will issue $20,0008\%$ loan notes with a nominal value

of $$100$ per loan note.

Extracts from the most recent Financial Statements of Everitt Ltd$.$ are provided below:

Everitt Ltd

Summary Statement of Financial Position prior to raising new finance:

Profit before interest and tax

Finance costs $($interest$)$

Taxation

Profit after tax

Equity

Ordinary shares

Retained earnings

Long$-$term liabilities:

$7\%$ loan notes

Total equity and long$-$term liabilities

$$\text{'}000$

$1,597$

$(315)$

$(282)$

$1,000$

$$000$

$[2,500],[5,488],[4,500]$

$12,488$

Further relevant information:

The current price$/$earnings ratio of Tin Co is $12\mathrm{.}5$ times. Corporation tax is payable at a rate of $22\%.$

Companies undertaking the same business as Everitt Co have an average debt$/$equity ratio $($book value

of debt divided by book value of equity$)$ of $60\mathrm{.}5\%$ and an average interest cover of $9$ times.

Required:

a$)$ Compute the following for Everitt $Co.$:

$($i$)$ Theoretical ex rights price per share

$($ii$)$ Assuming equity finance is used, calculate the revised earnings per share after the business

expansion.

$(4$ marks$)$

$($iii$)$ Assuming debt finance is used, calculate the revised earnings per share after the business

expansion.

$(5$ marks$)$

$($iv$)$ Calculate the revised share prices under both financing methods after the business

expansion.

$(2$ marks$)$

b$)$ Use calculations from part $($a$)$ to evaluate whether equity finance or debt finance should be used

for the planned business expansion.

$(12$ marks$)$