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- This topic has 3 replies, 2 voices, and was last updated 2 years ago by John Moffat.
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- June 5, 2021 at 6:12 pm #623324
Hello Sir, I am having problem with the understanding of the past question Bar Co (part b) where we are told to “Calculate & discuss whether using the cash raised by the rights issue to buy back bonds is likely to be financially acceptable to the shareholders”.
Please correct my understanding of this question such as:
1) We are seeing here whether the cash raised by the rights issue of amount $90m is financially viable to buy back the bond on its current market price of $112.50 in the future (we are not seeing when the company will buy back the bond in future rather we are seeing we have paid in full the bondholders)
2) We need to sell the bond first before buying back so we need to remove interest being paid on bond that we were paying amount of $6.4m = (80m x 8%)
3) How many ratios should we calculate to see whether the decision taken is resulting in increase in shareholders wealth?
I know that EPS & PE ratios were used for to see whether they have been increasing after the equity finance where EPS is reduced from $0.45 to $0.4237 while PE is remain constant (if I am correct because we used current PE ratio to calculate revised share price so PE remains the same before & after the issue – correct me here too please!)
Please correct me if you find me in error anywhere.
June 6, 2021 at 8:45 am #6233711. Not really. They can certainly use the $90M to buy back bonds. The question is as to whether this will be good for shareholders i.e. whether or not it will increase the shareholders weals,
2. No. How can we sell the bonds? The bonds have already been issued so they will use the $90M to buy the bonds and cancel them.
3. The TERP is the new share price after the rights issue that results in shareholders making no gain and no loss. As I explain in my lectures, the actual share price after the rights issue will depend on how the money raised is used. To see whether it is good for shareholders we need to compare the new share price with the TERP – if it is higher than shareholders wealth has increased, if lower than their wealth has decreased. We estimate the new share price by applying the PE ratio to the new EPS.
June 6, 2021 at 9:09 pm #623536Sorry but I could not understand the question completely 🙁 LET me put it this way
1)
REDEEM the debt simply refer to paying all the debt to its debtholders on Nominal Value?Bar Co has raised $90m from rights issue which they wanna use to buy back the bonds where we are seeing whether it is financially acceptable or not to the shareholders (i.e. increase Shareholders Wealth)
Bar Co currently has 8% bonds ($100 nominal) with $125m debt on its SOFP which is currently trading at $112·50 in the market & bondholders have agreed that they will allow to buy back the bonds at this market value.
(That means the company has redeemed the bond i.e. paid all the debts of $80m nominal value of the debt to debtholders and NOW they wanna buy this bond back on its $112.5 market value)
When the company paid $80m debts on nominal value shouldn’t they be left with only $10m of cash that was raised rights issue in total $90m?
2)
So, when the company redeem the bond, they will save interest which they had been paying for debt:Interest saved by redeeming bonds = 80m x 0·08 = $6·4 million per year
Since it is clear that we will have increase in EPS because the interest saved would increase in Profit after Tax which will eventually increase EPS.
3)
Also, is it true that when EPS increases so does the PE ratio since they both use common things to calculate them?Sorry for such a lengthy question. Thanks anyway 🙂
June 7, 2021 at 8:22 am #6235811. Redemption is repaying the bond on the due date at the nominal value (plus a premium if that was part of the agreement).
Here they are not redeeming the bonds – they are buying them back on the stock exchange at their market value and then cancelling them.2. When bonds are either redeemed (repaid) or are bought back and cancelled, then from then on there is no interest to pay because the bonds no longer exist!
3. No it is not true. If the EPS increases then the share price will increase. There is no reason why the PE ratio should change.
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