CFAP04 - Business Finance Decisions | Page 12

Gearing
 WFHL current debt/equity (book value basis) = 30/20 × 100% = 150%
 After bond issue debt/equity = 45/20 × 100% = 225%
 Average debt/equity = 80%

WFHL 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
 WFHL interest coverage ratio = 12/3 = 4 times
 After bond issue interest coverage ratio = 12/(3 + (1.5) = 2.7 times
 Average interest coverage ratio = 8 times

WFHL 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 WFHLuld have difficulty making the
interest payments.

The interest on the existing loan notes is Rs.2.4 million (8% × Rs.30 million) and the total interest charge
in the income statement is Rs.3 million. This implies that WFHL 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 Rs.15 million will not be found.

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 = Rs.2.30 × 80% = Rs.1.84

Theoretical ex-rights price

Rs.
4 shares @ Rs.2.30 9.20
1 share @ Rs.1.84 1.84
11.04

 Theoretical ex-rights price (TERP) = 11.04/5 = Rs.2.21

 Number of new shares to be issued = (5/0.5)/4 = 2.5 million
 Amount of finance that would be raised = Rs.1.84 × 2.5 million = Rs.4.6 million
Gearing
 Current debt/equity = 30/20 = 150%
 After rights issue debt/equity = 30/24.6 = 122%