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There is a question called Spine Co [Sep/Dec 2020] which is asking to calculate the effect on the wealth of the shareholders by the expansion of the company with debt & equity finance.
If Debt Finance is used then:
1) Interest payments will increase because now we have to pay interest to debtholders
2) PAT will be changed because we have higher interest cost paid on debtIf Equity Finance is used then:
1) Total number of shares will increase because now we have the right sharesTo calculate the increase in shareholders’ wealth under both debt & equity finance; Following ratios should be calculated and if these ratios indicate that there is an increase in debt finance or equity finance it should be preferred.
1) EPS
2) PE ratio
3) Capital gain (Current Share Price vs Revised Share Price)Is it the correct way to calculate the Effect on the wealth of the shareholders using the above ratios?
The object of the financial manager is to increase shareholders wealth, which is measured by the value of their shares.
To calculate the effect on the share price, given the information provided in this question, we need to apply the PE ratio to the EPS as in the examiners answer.
The EPS and the PE ratio need to be calculated in order to arrive at the new share price, but it is the share price (and the resulting gain or loss) that determines which is the more financially acceptable.
If we raise new finance by debt or equity; it will have an effect on its share price.
We used investor’s ratios to calculate the market value of shares after the issuance of debt or equity. If ratios indicate that there is an increase in the MV of shares then it is financially acceptable to shareholders because it results in increasing the shareholders wealth.
I understand that more debt causes equity holders to ask for a higher rate of return but why the more equity issue (ie rights issue) will result in affecting the market value of shares?
Spine Co has raised equity finance by issuing rights shares in the market & as we know from the TERP calculation that it always results in a lower new market share price so isn’t this result in a lower share price and would not be acceptable to shareholders?
Issuing more shares affects the market value per share because on the one hand there are more shares sharing the same profits, and on the other hand the finance raised (depending what the company does with the money) stands to change the future total profits.
If you have watched my lectures on rights issues you will know that the TERP is the new share price at which the shareholders make no gain and no loss. The MV per share is lower but each shareholder owns more shares (and they bought the new ones at a low price). At the TERP, the shareholders wealth in total is the same as it was before the rights issue.
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