Kijal Co is a stock-market listed company that manufactures consumer products and it is planning to expand its existing business. The investment cost of $5 million will be met by a 1 for 4 rights issue at a 10% discount to the current market price of $8·00 per share. Financial information relating to Kijal Co is as follows: Non-current assets Tangible assets Intangible assets Current assets Inventory Trade receivables Total assets Current liabilities Trade payables Overdraft Equity Ordinary shares ($1 par value) Reserves $000 3,000 8,500 11,500 4,100 11,100 15,200 26,700 5,200 4,500 9,700 10,000 7,000 17,000 26,700
Required: (a) (i) the theoretical ex rights price per share; (ii) the value of rights per existing share. (3 marks) (b) An investor owns 2,000 shares in Kijal Co and selects the following options: 1. Takes up his rights 2. Sells his rights 3. Buys 50% shares and sells 50% rights 4. Takes no action. Determine and discuss the effect of each of these actions on the wealth of the investor. (15marks) (c) Discuss the attractions of operating leasing and rights issue as a source of finance. (7 marks) (Total: 25marks)
the Management of Sura plc has discussed to alter the company's capital structure. and use the funds to repurchase its ordinary shares. (5 marks) c) What are the arguments for and against the use of book values and market values in establishing a company's target capital structure? (5 marks) (Total: 25marks)
. Issue costs and transactions costs can be ignored.000 Intangible assets 21.100 15. par value $1 Total non-current liabilities Current liabilities Total equity and liabilities
24. discuss the probable effect on the cost of capital of Sura plc after the company restructures its capital. To reduce the number of shares.100 11. the risk free rate is 4% and the estimated market return is 12%.800 Current assets Inventory Trade receivables Total assets Equity and liabilities Ordinary shares.QUESTION 2 During a recent meeting.000 25.200 40.500 5.000 2. Sura's equity beta is estimated by a reputable international rating agency to be 1. par value $1 Retained earnings Total equity 10% loan notes -2023 9% preference shares. A summary of Sura 's current financial position is shown below: $000 Non-current assets Tangible assets 3. Sura 's finance executive does not expect the market price of the existing ordinary shares or loan notes to change as a result of the proposed issue of new loan notes.500 27.000
The company's current ordinary share price is 180c. The company does not expect to pay corporate taxes for the foreseeable future.000 40. (15marks) b) Without performing any calculation. Loan notes interest is payable annually.18. a) Calculate the weighted average cost of capital before restructuring.000 2.500 5.800 4.500 7. the current ex div preference share price is $0. Sura plc has proposed to issue $6 million of new loan notes at par.90 and the loan notes price is $109.
=$16.000 =$15.00 2.00 2.680 =$320 =$16.20
When the investor Buys 50% shares and sells 50% rights.64 value of rights per existing share=$0.Suggested Answer Answer1 a) Current Market Price = $8.16 i.
.600) =$16. however he received cash from the sale of his rights amounting to $160 and invested $1. the wealth before and after the rights issue does not change.84-$7. however he received cash from the sale of his rights amounting to $320.640 =$160 = ($1.250x$7.20= $0.00 Rights issue price =$8.20
=$16. Before rights issue Wealth of an investor After rights issue Wealth of an investor
2. the wealth of the investor after the rights issue has dropped.000x$8.20]/5= $7. the value of his old shares(2. the investor’s wealth was in the form of cash but after the rights issue it was converted into shares.00x0.00 2.800 to purchase 250shares. Prior to rights issue. the wealth before and after the rights issue does not change. Buys 50% shares and sells 50% rights
Before rights issue Wealth of an investor After rights issue Wealth of an investor Cash from value of rights issue Cost of rights issue
2.000x$8.500x$7.000 =$15.84 500x$7. Takes no action v.84 500x$0. Takes up his rights
Before rights issue Wealth of an investor After rights issue Wealth of an investor Cost of rights issue
2.000x$8.84 250x$0. Sells his rights
Before rights issue Wealth of an investor After rights issue Wealth of an investor Cash from value of rights issue
2.20 TERP= [(4x$8.64 250x$7.000 =$17.000
When the investor sells his rights.000
When the investor exercise his rights.000 =$19.680
When the investor takes no action . after the rights issue.000x$7.000x$7.00 2. the value of his shares(2.00)+ $7. The cash from the value of rights is compensated with a fall in the old share value. the wealth before and after the rights issue does not change.000) dropped by $320.600 =($3. ii.250) dropped by $360. The investor has lost the value of the rights for 500shares which equals to $320.84 Value of rights=$7.64
=$16. iii.800) =$16.64/4=$0. After the rights issue.90= $7.000x$8.
5 x 10) + (0.616.5 = Increase in costs (94. Between these two extremes in policy terms lies a moderate or matching approach.01 x 0.712.000 Net benefit if adopt Proposal 2 $172.726 Increase in financing cost = Incremental costs = 26.02 = Increase in costs $19. Such a policy will decrease interest costs and increase profitability.Answer 2 (a) Evaluation of change in credit policy Current average collection period = 40 + 10 = 50 days Current accounts receivable = $24m x 50/ 365 = $3.328) x 0.521 Decrease in financing cost = Cost of discount = 24m x 0.4 x 50/ 365 = $3.000 24. moderate and aggressive.438 --3.06 = $94. a conservative policy would use long-term finance for permanent current assets and some of the fluctuating current assets. (6 marks)
.438 Increase in financing cost = (3.671 – 1.726
Contribution from increased sales = 24m x 0. This is an expression of the matching principle.5 x 40) = 25 days Current level of credit sales = $24 million Accounts receivable after change = $24 x 25/ 365 = $1.000 547. at the expense of increased interest payments and lower profitability.287.287.328 Decrease in financing cost = (3. If current assets are analysed into permanent and fluctuating current assets.712. characterised by short-term finance being used for all of fluctuating current assets and part/most of the permanent current assets as well.4 million Accounts receivable after change = $26.726 528.3 = $720. A conservative financing policy would involve financing working capital needs predominantly from long-term sources of finance.287.671) x 0. where short-term finance is used for fluctuating current assets and long-term finance is used for permanent current assets. An aggressive financing policy.616.274 Adopt Proposal 2 will increase the profitability of MM Co (13 marks) (b) Working capital policies on the method of financing working capital can be characterised as conservative.479
Proposal 2 Average collection period = 50 days New level of credit sales = $26.1 x 0. Such a policy would increase the amount of lower-risk finance used by the company.521) 120.06 = $19. which holds that the maturity of the finance should match the maturity of the assets.4m x 0.671 Proposal 1 Average collection period = (0. but at the expense of an increase in the amount of higher-risk finance used by the company.
500 4. These objectives are often in conflict. Taking steps to improve stock management can therefore reduce costs and increase shareholder wealth.000) (15.563 –––––– –––––––––––––– 9.750 4.089 –––––– ––––––– –––––––
.000) (13. although the optimum cash position will also depend on the precautionary and speculative need for cash. A similar case can be made for the management of stock.063 0·751 0·683 0·621 –––––– ––––––– ––––––– 7. aims to minimise the risk of bad debts and expedite the prompt payment of money due from account receivable in accordance with agreed terms of trade. Good stock management.500 20. leading to an increase in the returns available to shareholders.000) 16. Good working capital management is therefore necessary if the company is to survive and remain profitable.188 45.500 4.688 50. However.500 DF 1·0 0·909 0·826 –––––––– ––––––– –––––– DCF (360. For this reason cash is often called the lifeblood of the company. Taking steps to optimise the level and age of account receivable will minimise the cost of financing them. Cash budgets can help to determine the transactions need for cash in each budget control period.322 3.(c) The objectives of working capital management are often stated to be profitability and liquidity.133) 2015 3 2016 4 2017 5
(15. The different elements of good working capital management therefore combine to help the company to achieve its primary financial objective. liquidity is needed in the sense that a company must meet its liabilities as they fall due if it is to remain in business. since liquid assets earn the lowest return and so liquidity is achieved at the expense of profitability. (6 marks)
Answer 3 Parachute (a) Purchase outright 2012 2013 2014 Year 0 1 2 Outlay (360. Cash management models such as the Baumol model and the Miller-Orr model can help to maintain cash balances close to optimum levels.250 15. The fundamental objective of the company is to maximise the wealth of its shareholders and good working capital management helps to achieve this by minimising the cost of investing in current assets.000) Maintenance (15.000) (15. for example using techniques such as the economic order quantity model and buffer stock management can minimise the costs of holding and ordering stock. It is likely that Velm plc will need to have a good range of stationery and office supplies on its premises if customers’ needs are to be quickly met and their custom retained.202 31. The application of just-in-time methods of stock procurement and manufacture can reduce the cost of investing in stock.629 –––––––– ––––––– –––––– Net Present Cost = £(318.000) (15.500 WDA Tax Effect (W1) 27.675) 13. Good credit management.000 –––––––– ––––––– –––––– Cash flow (360. for example. since without cash a company would quickly fail.000) Tax relief 4.000) 4.
140 Net Present Cost = £(355.180) PV tax relief = (140.875
WDA 25% 90. managers must consider how much confidence can be placed in the results of the investment appraisal process. but this is theoretically possible only in a perfect capital market. Where such probabilities can be assigned.040)
On the basis of net present value.000 67. Risk refers to the situation where probabilities can be assigned to future cash flows. purchasing outright appears to be the least cost method.(W1) Writing down allowances Year TWDV b/d 2013 360.000 2015 202.e.000)3·17 = (475.625 151.188 45.875
Tax Effect 30% 27.000 x 0·3)3·17]/1·1 = 129.000)(2·487 +1) = (488.500 50. or they may fail to monitor investment projects in order to ensure that expected results are in fact being achieved. the more uncertain is its value. it is possible to quantify the risk associated with project variables and hence of the project as a whole. a capital market where there is no limit on the finance available. companies are limited in the funds that are available for investment. Since future cash flows cannot be predicted with certainty.562-Balancing allowance
Finance lease Annuity Factor (AF) at 10% for 4 years is 3·17 Thus PV outflows = (135.500) PV tax relief = [(150. the basis for investment decisions should still be to maximise the wealth of shareholders.000 x 0·3)(2·487 +1)/1·1 = 133. They must therefore be concerned with the risk and uncertainty of a project.682 Net Present Cost = £(345. or projects that might be worthy of reconsideration if ways of reducing project risk could be found in order to make project outcomes more acceptable. However. If risk and uncertainty were not considered in the investment appraisal process.818) Operating lease Annuity Factor (AF) at 10% for 3 years is 2·487 Thus PV outflows = (140. (5 marks) (c)In real-world capital investment decisions. managers might make the mistake of placing oo much confidence in the results of investment appraisal. Uncertainty cannot therefore be quantified and increases with project life: it is usually true to say that the more distant is a cash flow. The NPV decision rule calls for a company to invest in all projects with a positive net present value.
(12 marks) (b) The investment appraisal process is concerned with assessing the value of future cash flows compared to the cost of investment.500 2016 151.250 15.000 20. i.000 2014 270. Uncertainty refers to the situation where probabilities cannot be assigned to future cash flows.000 + 15. Assessment of project risk can also indicate projects that might be rejected as being too risky compared with existing business operations.
. for example as a result of managerial experience and judgement or scenario analysis.
which is possible with divisible investment projects. Capital may be in short supply due to ‘crowding out’ as a result of high government borrowing. in order to select the combination of projects with the highest NPV. the company may limit the funds available for capital investment in order to encourage competition between potential investment projects. (8 marks) Answer 4
(a) Po Pd Pps = $ 1. the amount of funds needed may be small in relation to the costs of raising the finance: or the company may wish to avoid dilution of control or earnings per share by issuing new equity. so that there is a general unwillingness by investors to provide funds for capital investment. where investment funds are limited in the first year only. injection of funds into the circular flow of income so as to encourage or assist recovery from an economic recession. within the limit of the investment funds available. the amount of surplus funds is irrelevant to the selection of the optimal investment schedule.80/share = $109 = $0. This is the ‘internal capital market’ reason for soft capital rationing. Soft capital rationing may be due to reluctance by a company to raise finance. the total NPV of various combinations of projects must be compared. such as that investors may feel that a company is too risky to invest in.90 ( 2marks)
Ke = 4%√+1. This may require partial investment in the last desirable project selected.18√ (12-4)% √√ =13. or as the present value of future cash flows divided by the initial investment. This will be the optimum investment decision. For example. but since the highest-NPV combination has been selected.44%
. it must ensure that it generates the maximum return per dollar invested. Several reasons have been suggested for hard capital rationing. If a company cannot invest in all projects with a positive NPV. Where investment projects are not divisible. Perhaps capital markets may be depressed. moving from highest profitability index downwards. Investing these surplus funds in a bank or in the money market would have an NPV of zero. Alternatively. so that only robust investment projects are accepted. This can be defined either as the NPV divided by the initial investment. or the company may wish to avoid a commitment to paying fixed interest because it believes future economic conditions may put its profitability under pressure. The reasons why investment funds are limited in the real world are either external to the company (hard capital rationing) or internal to the company (soft capital rationing). The optimal investment decision for a company is then to invest in the projects in turn. Surplus funds may be left over.Since investment funds are limited in the real world. With single-period capital rationing. until all the funds have been exhausted. divisible investment projects can be ranked in order of desirability using the profitability index. it is not possible in the real world for a company to invest in all projects with a positive NPV. with its credit rating being seen as too low for the amount of investment it needs.
.90 :. A balance sheet method might enable a distinction to be made between tangible and non tangible assets. with increase in loan notes.rather than intangible assets which although having value in a continuing businesses.722√ 0.48 + 0.
C ) A company’s target capital structure in terms of gearing ratio is regarded as an indicator of
risk as high level of debt create a high fixed interest commitment which must be paid by the company irrespective of whether profits are made or not.25m√√ = RM 5.45√ 38.Preference dividend = 9% x $1 = $0.614√
( 1 mark) (1 mark)
PV (109) 77.5m x $0. Therefore.40√ NPV 29. lenders have been more willing to advance loans on the basis of tangible. The use of market values can be more realistic where balance sheet values bear little resemblance to current values and where valuable assets e.g brand names and trademarks are not included on the balance sheet. the overall cost of capital should be lower after capital restructuring. However. assuming that there is no change in the cost of equity and cost of debt for the new loan notes is same as yield to maturity of old loan notes. the gearing level is expected to rise. the two methods have little or no resemblance.386√
PV (109) 61.145√ 0. i. the proportion of higher cost of equity has dropped and the proportion of lower cost of debt has increased with proposed issue of $6million loan notes.60√ NPV (8.22√ 61.43 + 0.70m
WACC = (11.e physical assets which are usually saleable.09 or 9 cent kps = $0. c) Under tradional When the company repurchases its own shares.82% √
b) Probable effect after capital restructuring can be explained using Tradional theory. As such.95)
MV of equity MV of preference share MV of Loan notes
= 25m shares x $1. MM without tax and MM with tax.80 = 2.9 Total market value
= $45m√√ = RM 2.45m√√ $52.91)% = 12. may have little or no value if the business is discontinued. The financial risk will be high. However. Kps = 9cent = 10% 90cent Year 0 1-10 10 (3marks) Cash flow RM (109) √ 10√ 100√ DF/AF 5% 1 7. therefore equity shareholders need to be compensated for higher financial risk.62
DF@10% 1 6. In the past. A company’s management need to recognise that debt and equity relationships can be expressed in terms of market value or book value. the cost of equity is expected to rise.
000x$8.84 500x$7.800) =$16.90= $7.500x$7.000x$8.000 When the investor sells his rights.84 Value of rights=$7.640 =$160 = ($1.000x$8.84 500x$0.84-$7.00 2.20
=$19.20 TERP= [(4x$8. Sells his rights Before rights issue Wealth of an investor After rights issue Wealth of an investor Cash from value of rights issue
=$16.250) dropped by $360.64/4=$0.a) Current Market Price = $8.600) =$16.000 When the investor Buys 50% shares and sells 50% rights.00 Rights issue price =$8.84 250x$0.64 value of rights per existing share=$0. the wealth before and after the rights issue does not change. after the rights issue. Prior to rights issue.64 250x$7. however he received cash from the sale of his rights amounting to $160 and invested $1.000 When the investor exercise his rights.00 2.00)+ $7.00 2. Takes no action Before rights issue
.600 =($3.000) dropped by $320.20
=$15. After the rights issue. The cash from the value of rights is compensated with a fall in the old share value.20]/5= $7. the investor’s wealth was in the form of cash but after the rights issue it was converted into shares.00x0.000x$7.680 =$320 =$16. the value of his old shares(2.16 b) Takes up his rights Before rights issue Wealth of an investor After rights issue Wealth of an investor Cost of rights issue
2.800 to purchase 250shares. however he received cash from the sale of his rights amounting to $320.000
=$17.20= $0. the wealth before and after the rights issue does not change. Buys 50% shares and sells 50% rights Before rights issue Wealth of an investor After rights issue Wealth of an investor Cash from value of rights issue Cost of rights issue
2. the wealth before and after the rights issue does not change. the value of his shares(2.250x$7.
A rights issue would not necessarily disturb the existing balance of ownership and control between shareholders. There is no need to arrange a loan in order to acquire an asset and so the commitment to interest payments can be avoided.000x$8.000x$7. Rights issue will decrease gearing. and can also extend to contract terms and servicing cover.
c. Rights issue is permanent capital that does not need to be redeemed. Rights issue In this method of raising new equity finance. Since legal title does not pass from lessor to lessee. A portion of these benefits can be made available to the lessee in the form of lower lease rentals. Operating leasing can therefore be attractive to small companies or to companies who may find it difficult to raise debt. This flexibility is seen as valuable in the current era of rapid technological change. The financial risk faced by the company would thus be reduced. making operating leasing a more attractive proposition that borrowing. A rights issue will not dilute existing patterns of ownership and control.680 When the investor takes no action . new shares are offered to existing shareholders pro rata to their existing shareholdings. for example by taking advantage of bulk buying. and the right to attend general meetings of the company. the leased asset can be recovered by the lessor in the event of default on lease rentals. Operating leasing can also be cheaper than borrowing to buy.Wealth of an investor 2. an operating lease is seen as protection against obsolescence. making it a more attractive investment prospect on the stock market. since it can be cancelled at short notice without financial penalty. Operating leasing is a popular source of finance for companies of all sizes and many reasons have been advanced to explain this popularity. Redeeming a large amount of debt can place a severe strain on the cash flow of a company. existing assets need not be tied up as security and negative effects on return on capital employed can be avoided. the wealth of the investor after the rights issue has dropped. The investor has lost the value of the rights for 500shares which equals to $320. Shareholders also have the right to appoint directors and auditors.000 After rights issue Wealth of an investor 2. There are several reasons why the lessor may be able to acquire the leased asset more cheaply than the lessee.84 =$15. This could have a positive effect on the company’s share price. Operating leasing is often compared to borrowing as a source of finance and offers several attractive features in this area.
Answer 2 (a) Po Pd = $ 1. The lessor may also be able use tax benefits more effectively than the lessee. Operating leases also have the attraction of being off-balance sheet financing. The lessor will replace the leased asset with a more up-to-date model in exchange for continuing leasing business.80/share = $109
. in that the finance used to acquire use of the leased asset does not appear in the balance sheet. unlike an issue of shares to new investors.00 =$16. For example. or by having access to lower cost finance by virtue of being a much larger company.
= $0.91)% = 12.40√ NPV 29.722√ 0.22√ 61.44%
Preference dividend = 9% x $1 = $0.60√ NPV (8.9 = $45m√√ = RM 2.80 = 2. Kps = 9cent = 10% 90cent
( 1 mark)
Year 0 1-10 10 (3marks)
Cash flow RM (109) √ 10√ 100√
DF/AF 5% 1 7.45√ 38.48 + 0.62
DF@10% 1 6.09 or 9 cent Pps = $0.45m√√ Total market value $52.90
Ke = 4%√+1.5m x $0.70m
WACC = (11.82% √ (5 marks)
PV (109) 77.43 + 0.386√
PV (109) 61.95)
WACC MV of equity MV of preference share MV of Loan notes = 25m shares x $1.145√ 0.18√ (12-4)% √√ =13.25m√√ = RM 5.
c. assuming that there is no change in the cost of equity and cost of debt for the new loan notes is same as yield to maturity of old loan notes. Probable effect after capital restructuring When the company repurchases its own shares. However. The financial risk will be high. the cost of equity is expected to rise. the proportion of higher cost of equity has dropped and the proportion of lower cost of debt has increased with proposed issue of $6million loan notes. with increase in loan notes. i.
. A balance sheet method might enable a distinction to be made between tangible and non tangible assets.b.rather than intangible assets which although having value in a continuing businesses. may have little or no value if the business is discontinued. However. lenders have been more willing to advance loans on the basis of tangible.g brand names and trademarks are not included on the balance sheet. A company’s management need to recognise that debt and equity relationships can be expressed in terms of market value or book value. the two methods have little or no resemblance. The use of market values can be more realistic where balance sheet values bear little resemblance to current values and where valuable assets e. As such. the overall cost of capital should be lower after capital restructuring. Therefore.e physical assets which are usually saleable. therefore equity shareholders need to be compensated for higher financial risk. In the past. A company’s target capital structure in terms of gearing ratio is regarded as an indicator of risk as high level of debt create a high fixed interest commitment which must be paid by the company irrespective of whether profits are made or not. the gearing level is expected to rise.