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Dear John,
Could you please explain to me that in the question 4 Section 4 of ACCA F9 Past exam (June 2015) why the revised earnings after redeeming loan notes =Previous earnings + after-tax interest saving?
The questions is:
Grenarp Co is planning to raise $11,200,000 through a rights issue
The new shares will be offered at a 20% discount to the current share price of Grenarp Co, which is $3·50 per share
The rights issue will be on a 1 for 5 basis and issue costs of $280,000 will be paid out of the cash raised
The capital structure of Grenarp Co is:$m
Equity
Ordinary shares ($0.50 nominal) 10
Reserves 75Non-current liabilities
8% loan notes 30The net cash raised by the rights issue will be used to redeem part of the loan note issue. Each loan note has a nominal value of $100 and an ex interest market value of $104
A clause in the bond issue contract allows Grenarp Co to redeem the loan notes at a 5% premium to market price at any time prior to their redemption date. The price/earnings ratio of Grenarp Co is not expected to be affected by the redemption of the loan notes.The earnings per share of Grenarp Co is currently $0·42 per share and total earnings are $8,400,000 per year. The company pays corporation tax of 30% per year.
Evaluate the effect on the wealth of the shareholders of Grenarp Co of using the net rights issue funds to redeem the loan notes.
The solution provided:
Rights issue price = 3·50 x 0·8 = $2·80 per share
Grenarp Co currently has 20 million shares in issue ($10m/0·5) The number of new shares issued = 20m/5 = 4 million shares
Cash raised by the rights issue before issue costs = 4m x 2·80 = $11,200,000
Net cash raised by the rights issue after issue costs = 11,200,000 – 280,000 = $10,920,000
Revised number of shares = 20m + 4m = 24 million shares
Market value of Grenarp Co before the rights issue = 20,000,000 x 3·50 = $70,000,000 Market value of Grenarp Co after the rights issue = 70,000,000 + 10,920,000 = $80,920,000
Theoretical ex rights price per share = 80,920,000/24,000,000 = $3·37 per shareRedemption price of loan notes = 104 x 1·05 = $109·20 per loan note Nominal value of loan notes redeemed = 10,920,000/(109·20/100) = $10,000,000
Before-tax interest saving = 10,000,000 x 0·08 = $800,000 per year
After-tax interest saving = 800,000 x (1 – 0·3) = $560,000 per year
Earnings after redeeming loan notes = 8,400,000 + 560,000 = $8,960,000 per year (I don’t understand why they adding after-tax saving to Earnings? Is it because they treated the saving as other income)?Please do not type out full questions like this – it is copyright of the ACCA and they get annoyed when their questions are reprinted like this.
I have all the past exam questions so you only need to say the name and which exam!If the loan notes are redeemed, then they will no longer be paying interest on them and s the profit will be higher as a result. Tax is always calculated after the payment of any interest, and so if the profits are higher (because of paying less interest) then there will be more tax payable. The net effect is that the profit will be higher by the amount of the interest less tax.
@johnmoffat said:
Please do not type out full questions like this – it is copyright of the ACCA and they get annoyed when their questions are reprinted like this.
I have all the past exam questions so you only need to say the name and which exam!If the loan notes are redeemed, then they will no longer be paying interest on them and s the profit will be higher as a result. Tax is always calculated after the payment of any interest, and so if the profits are higher (because of paying less interest) then there will be more tax payable. The net effect is that the profit will be higher by the amount of the interest less tax.
Thank John for your remind and kind explanation. I fully understand now.
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