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May 31, 2017 at 3:38 pm #389257svanzundert
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I am stuck on a question that I can’t seem to solve with whatever logic I use. The question is as follows:
Story: A company is investing $70m in a new project and will be funding part of the investment by debt and the remainder by equity through a rights issue. The current share price is $4 and the market capitalisation is $200m. The rights issue price will be at a discount of 20% to the current share price. The rights issue will be on a 1 for 5 basis Issue costs are expected to be $2m. Current equity gearing (debt/equity) is 40%.
Question: What is the revised equity gearing of the company?
The answer booklet gives C, 40.7% as the correct answer (but sadly no clear workings).
I have however given it an attempt based on the knowledge obtained:
Rights issue (sadly it doesn’t look proper when posting the question…):
Shares Price Total
5 4 20
1 3.20 3.20
Ex.rights price = 23.30 / 6 = 3.87
New Market Capitalisation is 60,000,000 shares times 3.87 = 232,200,000
Gain of the issue is 10,000,000 times 3.20 = 32,000,000
Cost of the issue is 2,000,000, therefor net gain = 30,000,000
This would leave me to issue a further 40,000,000 in debt to obtain the 70,000,000 required for the investment.
Given that the debt/equity ratio is 40% and the only given figure was 200,000,000 equity, the debt must be 80,000,000. With the 40,000,000 issue of debt, the debt would now become 120,000,000.
Therefor new gearing would be 120,000,000 / 232,200,000 giving me 52%. But that is far off from the given answer.
I would hope to receive some insights that can clear me mind.
Many thanks in advance, wish you a nice day.May 31, 2017 at 6:10 pm #389295John MoffatKeymaster
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If you have copied the whole of the question correctly, then the answer is certainly wrong (and your answer is correct).
If it is a past exam question or from the current edition of the BPP Revision Kit, then say which question and I will check the wording myself 🙂
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