BBMF2814 FINANCIAL MANAGEMENT 2 RAC

Week 6 Tutorial Answers (PAVLON, DD & ECHO)

__________________________________________________________________________________

Question 1 (PAVLON)

1
BBMF2814 FINANCIAL MANAGEMENT 2 RAC
Week 6 Tutorial Answers (PAVLON, DD & ECHO)
__________________________________________________________________________________

Question 2 (DD)

2
BBMF2814 FINANCIAL MANAGEMENT 2 RAC
Week 6 Tutorial Answers (PAVLON, DD & ECHO)
__________________________________________________________________________________

Question 3 (ECHO)

(a) Proposal A – Increasing the dividend per share

The dividend paid last year was $2m which equates to 20c per share ($2m/$5m × 0.5). A 20%
increase would result in a dividend payment of 24c, a total dividend of $2.4m ($2m × 1.2). This
would reduce dividend cover from 3 times ($6m/$2m) to 2.5 times ($6m/$2.4m).

Dividends as a signal to investors

The ultimate objective in any financial management decisions is to maximise shareholders'
wealth. This wealth is basically represented by the current market value of the company, which
should largely be determined by the cash flows arising from the investment decisions taken by
management.

3
BBMF2814 FINANCIAL MANAGEMENT 2 RAC
Week 6 Tutorial Answers (PAVLON, DD & ECHO)
__________________________________________________________________________________

Shareholders will look at a number of factors when analysing investments and not just dividends.
They will be particularly interested in the business and financial risk of the company and will
not necessarily be impressed with a large increase in dividends.

The dividend declared can be interpreted as a signal from directors to shareholders about the
strength of underlying project cash flows. Investors usually expect a consistent dividend policy
from the company, with stable dividends each year or, even better, steady dividend growth.

Modigliani and Miller

Modigliani and Miller (MM) proposed that in a tax-free world, shareholders are indifferent
between dividends and capital gains, and the value of a company is determined solely by the
'earning power' of its assets and investments.

MM argued that if a company with investment opportunities decides to pay a dividend, so that
retained earnings are insufficient to finance all its investments, the shortfall in funds will be
made up by obtaining additional funds from outside sources. If a company pursues a consistent
dividend policy, 'each corporation would tend to attract to itself a clientele consisting of those
preferring its particular payout ratio, but one clientele would be entirely as good as another in
terms of the valuation it would imply for the firm'.

Conclusion
The proposal to increase the dividend should be rejected as it will not generate any additional
funds for the company and shareholders will not necessarily be attracted by the increase.

(b) Proposal B – Bond issue

Gearing
Echo Co current debt/equity (book value basis) = $30m/$20m × 100% = 150%
After bond issue, debt/equity = $30m + $15m = $45m/$20m × 100% = 225%
Average debt/equity = 80%

Echo Co is currently very highly geared with a debt to equity ratio based on book values of
almost twice that of the average of similar companies. A bond issue would increase the gearing to
even higher levels.

Interest coverage
Echo Co interest coverage ratio = $12m/$3m = 4 times
After bond issue, interest coverage ratio = $12m/($3m + $1.5m) = 2.7 times
Average interest coverage ratio = 8 times

Echo Co currently has half the interest coverage of similar companies which indicates a much
higher level of financial risk. The bond issue would further increase this risk and Echo could
have difficulty making the interest payments.

The interest on the existing loan notes is $2.4m (8% × $30m) and the total interest charge in the
income statement is $3m. This implies that Echo Co also has an overdraft which further
increases the level of financial risk.

Lack of investment opportunities

There are currently no suitable investment opportunities available and the bond issue proceeds
would be invested short-term. The return on short-term investments will be lower than the interest
charged on the loan notes, so there will be an opportunity cost which will decrease shareholder
wealth. There is a significant risk that a suitable investment opportunity requiring exactly $15m
will not be found.

4
BBMF2814 FINANCIAL MANAGEMENT 2 RAC
Week 6 Tutorial Answers (PAVLON, DD & ECHO)
__________________________________________________________________________________
Loan redemption
The current loan notes are due to be redeemed in three years’ time and this would be followed
five years later by a repayment of the bond issue. This raises issues for the financial planning of
the company which needs to consider how best to refinance.

Conclusion
The proposal to make a bond issue should be rejected as the level of financial risk is already too
high.

(c) Proposal C – Rights issue

Rights issue price = $2.30 × 80% = $1.84

Theoretical ex-rights price

$
4 shares @ $2.30 9.20
1 share @ $1.84 1.84
5 11.04

Theoretical ex-rights price (TERP) = $11.04/5 = $2.21

Number of new shares to be issued = ($5m/$0.5)/4 = 2.5 million

Amount of finance that would be raised = $1.84 × 2.5m = $4.6 million

Gearing
Current debt/equity = $30m/$20m = 150%
After rights issue, debt/equity = $30m/($20m + $4.6m) = 122%

As discussed in part (b), the current level of financial risk of Echo Co is unacceptably high and
needs to be reduced. The rights issue would reduce the level of gearing to 122% but this is still
higher than the average for similar companies.

Interest coverage
Current interest coverage ratio = $12m/$3m = 4 times
Current return on equity = $6m/$20m × 100% = 30%

Assuming the rate of return on the new equity will be the same:
After-tax return on the new funds = $4.6m × 30% = $1.38 million
Before-tax return on the new funds = $1.38m × ($9/$6) = $2.07 million
After rights issue interest coverage = ($12m + $2.07m)/$3m = 4.7 times

The interest coverage ratio would improve after the rights issue but again, is still worse than the
average for similar companies.

Purpose of the rights issue

The aim of the rights issue is to reduce the level of gearing and the financial risk of the
company. To some extent, this would be achieved but, in order to make more of a significant
impact, the level of debt would need to be reduced much further. The amount of refinancing
required is much greater than $4.6m and there is no indication that a suitable investment has been
identified.

Unless more information can be provided on how the rights issue proceeds could be effectively
used, the rights issue proposal cannot be recommended.

Note: You could sensibly have assumed that the equity raised will be used to reduce debt – this
will result in a different gearing calculation and interest coverage ratio

5
BBMF2814 FINANCIAL MANAGEMENT 2 RAC
Week 6 Tutorial Answers (PAVLON, DD & ECHO)
__________________________________________________________________________________