June 2013 – Question No. 4

Sir please explain how to answer this question (June 2013 Q4)

GXG Co is an e-business which designs and sells computer applications (apps) for mobile phones. The company
needs to raise $3,200,000 for research and development and is considering three financing options.
Option 1
GXG Co could suspend dividends for two years, and then pay dividends of 25 cents per share from the end of the
third year, increasing dividends annually by 4% per year in subsequent years. Dividends in recent years have grown
by 3% per year.
Option 2
GXG Co could seek a stock market listing, raising $3·2 million after issue costs of $100,000 by issuing new shares
to new shareholders at a price of $2·50 per share.
Option 3
GXG Co could issue $3,200,000 of bonds paying annual interest of 6%, redeemable after ten years at par.
Recent financial information relating to GXG Co is as follows:
$000
Operating profit 3,450
Interest 200 ––––––
Profit before taxation 3,250
Taxation 650 ––––––
Profit after taxation 2,600
Dividends 1,600
$000
Ordinary shares (nominal value 50 cents) 5,000
Under options 2 and 3, the funds invested would earn a before-tax return of 18% per year.
The profit tax rate paid by the company is 20% per year.
GXG Co has a cost of equity of 9% per year, which is expected to remain constant.

Required:
(a) Using the dividend valuation model, calculate the value of GXG Co under option 1, and advise whether
option 1 will be acceptable to shareholders. (6 marks)
(b) Calculate the effect on earnings per share of the proposal to raise finance by a stock market listing
(option 2), and comment on the acceptability of the proposal to existing shareholders. (5 marks)
(c) Calculate the effect on earnings per share and interest cover of the proposal to raise finance by issuing new
debt (option 3), and comment on your findings. (5 marks)
(d) Discuss the factors to be considered in choosing between traded bonds, new equity issued via a placing and
venture capital as sources of finance. (9 marks)
(25 marks)