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A company is planning to raise 300m finance from 3 possible sources
1An issue of ordinary shares. The company proposes to make a rights issue at a 10%discount to the current market price
2. An issue of a ten-year 7% $300 million Eurodollar bond (secured).
(3) A sale of 8% convertible unsecured loan stock of £100 each. Each of these can beconverted by holders at any time into 40 ordinary shares. Any outstanding stocks willbe redeemed at par in five years’ timeBAlance sheet items
non current liabilities (sterlings)
10% debentures 300capital and reserves
ordinary shares(50p par) 500
reserves 1000The current exchange rate of £1=$1.50 is expected to be maintained in the medium term ..discuss financial implications of all 3 options by calculating gearing(debt/equity book value basis) i am not able to understand the implications of 2nd and 3rd option on debt and equity please help me out thanks !!!
I do not think that you have given me all the information in the question.
The reason I say that is that if they are raising 300M (presumably in sterling?) then the book values of the non-current liabilities will simply rise by £300M (and the equity will remain the same).
However, issuing a $300M (dollar) bond will not raise the 300M they require, which is why I think you have not given me all the information.
Also, issuing convertible loan stock would mean extra arithmetic if you were required to calculate the gearing based on market values, but if it is based on book (balance sheet) values then if they raise £300M, then again the book value will increase simply by £300M.
Thecompany feels that it requires another £200 million finance to support new operations for thenext eight years, and it has identified three possible sources:(1) An issue of ordinary shares. The company proposes to make a rights issue at a 10%discount to the current market price.(2) An issue of a ten-year 7% $300 million Eurodollar bond (secured).(3) A sale of 8% convertible unsecured loan stock of £100 each. Each of these can beconverted by holders at any time into 40 ordinary shares. Any outstanding stocks willbe redeemed at par in five years’ time.The balance sheet for Borrows at 31 March 20X7 is as follows:£m £mNon-current assets 1,400Current assets 600Less: Current liabilities* (200) ___ Net current assets 400 _____ 1,800Less: Non-current liabilities:10% debentures (300) _____ Net assets 1,500 _____ Capital and reservesIssued ordinary shares (50p par) 500Reserves 1,000 _____ 1,500 _____ *Current liabilities include £80 million overdraft.The current market price per share is 210p, and price per debenture £90 per cent.The current exchange rate of £1=$1.50 is expected to be maintained in the medium term.The income statement (year-end 31 March 20X7) for the company is:£mOperating profit* 208
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Interest40 ___ Earnings before tax 168
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Tax (30%)50 ___ Earnings attributable to ordinary shareholders 118 ___ *Operating profit is expected to increase to £250m per annum after expansion into oilexploration.Discuss the financial implications of all three options by calculating the followingaccounting ratios:(i) gearing (book value of debt/book value of equity)(ii) earnings per share(iii) interest cover
sorry this was the complete question i missed some information
I don’t know where you got this question from, but it is not an exam question. The reason I mention this is that although the examiner does ask similar sorts of questions from time to time, he is more specific. (For example, he would usually just ask you to calculate the effect on the various ratios in one years time.) Also, to be able to give a full answer you would need to know the company’s dividend policy (I will explain why later).
The sort of thing to do is to forecast the income statement for each of the three options.
The operating profit will be 250M, the interest will either stay at 40M (with the rights issue) or will increase to 54M (with the bond) or increase to 56M (with the loan stock).You can then easily calculate the interest cover and the earnings per share (the number of shares obviously increasing with the rights issue, but staying the same as at present with the other two sources).
You would also calculate the current values of the ratios so that you can compare and discuss.Gearing is a problem, because the book value of the equity (capital + reserves) will increase each year by the amount of the earnings retained. However, without being told the dividend policy and therefore not knowing how much dividend will be paid, it is not possible to calculate the retention and therefore the book value of the equity.
The book value of the debt is no problem – it increases by $200M raised in the case of the second two choices. (However, it would be good to make the point that you could include or exclude the overdraft – it depends whether it is intended to be long-term (in which case include) or short-term (in which case exclude).
So….you cannot do much by way of calculations on the gearing (except obviously the current gearing) but you can still discuss the fact the certainly the second two choices will increase the gearing (more risk) but the first option will reduce the gearing.
Other points that are worth discussing are firstly that although the exchange rate is expected to be stable, it obviously could change, and this therefore makes extra risk for the eurodollar bond.
Also, in relation to the loan stock, there are several things to discuss – how likely are the holders to convert (how likely is the share price to increase about 2.50); if they do not convert because the share price does not increase enough, then where will the cash come from to repay; and the fact that if they convert the gearing will reduce, but if they do not convert then depending on how the company finds the necessary cash the gearing could go either way!!
Hope that helps a bit 🙂
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