Financial Management For Decision Makers Canadian 2nd Edition Atrill Solutions Manual

Chapter 9
Financing a Business 2: Raising Long-Term Funds
Answers to Review Questions
9.1 Various reasons have been put forward to explain the difference in the proportion
of total investment made in business start-ups by Canadian and U.S. venture
capitalists. These include:
• Canadian venture capitalists are more cautious than their U.S. counterparts. Start-
ups are more risky and Canadian venture capitalists may be less willing to take on
these risks.
• Canadian venture capitalists have a shorter-term investment perspective that makes
them prefer financing existing businesses.
• There is greater competition among U.S. venture capitalists for good investment
opportunities, which leads them to invest in business start-ups to achieve the
required returns.
• U.S. venture capitalists have more funds to invest so they can invest more in
startups.
9.2 A listed business may wish to revert to unlisted status for a number of possible
reasons. These include:
• Cost. A stock exchange listing can be costly, as the business must adhere to
certain administrative regulations and financial disclosures (especially in the post-
Enron/WorldCom fraud era when the Sarbanes-Oxley Act of 2002 in the U.S.
created significant new regulatory and accounting requirements).
• Scrutiny. Listed businesses are subject to close scrutiny by analysts and this may
not be welcome if the business is engaged in sensitive negotiations or
controversial activities.
• Takeover risk. The shares of the business may be purchased by an unwelcome
bidder and this may result in a takeover.
• Investor profile. If the business is dominated by a few investors who wish to
retain their interest in the business and do not wish to raise further capital by
public issues, the benefits of a listing are few.
9.3 A bought deal involves an investment dealer buying the shares in the business and
then, in turn, selling the shares to the public. The risk is borne by the investment
dealer. The issue will be advertised by the publication of a prospectus that will set
out details of the business and the issue price of the shares (or reserve price if a
tender issue is being made).
Copyright © 2012 Pearson Canada Inc. 178

Chapter 9
In a best efforts issue, the investment dealer does not guarantee a price for the new
IPO. A best efforts issue runs the risk that the shares will not be sold and is a less
popular form of issue for businesses.
9.4 A business should have owners who are:
• Committed to realizing the growth potential of the business

• Prepared to sell some of the common shares in the business
• Comfortable with the financing arrangements that venture capitalists usually
employ.
• Prepared to invest a sizeable portion of their own money in the business.
A business should have a management team that is:
• Ambitious
• Experienced
• Capable
• Well balanced.
9.5 Warren Buffett’s success as an investor is an argument against the efficient market
hypothesis. The efficient market hypothesis implies that one cannot consistently
beat the market. That is, the best an investor can hope for over a long period is to
match the returns of the stock market averages. Mr. Buffett seems to have found a
way to exploit some market inefficiency to earn superior returns throughout his
long investment career.
Solutions to Problems and Cases
9.1 5 Situations
1. Semi-strong form of market efficiency - because the formal announcement led to

a sharp drop in the share price.
2. Strong form of market efficiency - because the formal announcement did not
cause the share price to change significantly.
3. Strong form of market efficiency - because the formal announcement did not
cause the share price to change significantly.
4. Semi-strong form of market efficiency - because the formal announcement led to

a sharp increase in the share price.

Chapter 9
5. Weak form of market efficiency - because the share price seems to be fluctuating
randomly.
9.2 Students should draw straight line trend lines connecting at least three points, up or
down channels, triangles, cup with handle, or other trend lines as appropriate to
each company’s stock chart.
9.3 ETF Investments
You should buy ETFs in the small cap sector and the TSX 100 because they have the
highest 1-year growth rates.
Sector Now 1 Year Ago % Increase

Small Cap Index 7,500 5,600 33.93%
Median Cap Index 3,200 2,600 23.08%
Large Cap Index 8,000 7,000 14.29%
TSX 100 10,430 8,000 30.38%
9.4 J. Muserandathon Portfolio
(a)
Year J. Muserandathon S&P/TSX Composite %

end Portfolio % change Index change
2002 $ 90,000 6,615
2003 $ 89,000 -1.11% 8,221 24.28%
2004 $ 93,000 4.49% 9,247 12.48%
2005 $ 99,000 6.45% 11,272 21.90%
2006 $125,000 26.26% 12,908 14.51%
2007 $143,000 14.40% 13,833 7.17%
2008 $ 93,000 -34.97% 8,988 -35.03%
(b) Miss Muserandathon fared rather poorly in her investment results from 2002 to
2005. She lost money in 2003, when the TSX returned a stellar 24.28%. From 2003
to 2005, her returns were significantly below the TSX Composite Index returns.
However things have turned around since then as she roundly beat the market index
in 2006 and 2007. In the great recession of 2008, her performance matched the
index with a loss of nearly 35%.

Chapter 9
9.5 Your Company

(a)
A Ltd. B Ltd. C Ltd. D Ltd.

Term of investment (in years) 10 5 7 4
Amount invested $ 100 $ 40 $ 77 $ 56
IPO value at end of term of
investment 300 56 89 70
Discount factor
(Amount invested/IPO value) 0.3333 0.7143 0.8652 0.8000
IRR (from Table A2) 12% 7% 2% 6%
(b) Your company should only invest in A Ltd. as that investment is the only one with an
internal rate of return larger than your company’s 9% cost of capital.
9.6 Your Company

(a)
One Ltd. Two Ltd. Three Ltd. Four Ltd.

Term of investment (in years) 15 10 6 5
Amount invested $ 250 $ 110 $ 180 $ 450
Annual cash from dividend at end of each
year 24.1 12.8 40 130
Annuity discount factor
(Amount invested/annual cash received) 10.3734 8.5938 4.5000 3.4615
IRR (from Table A4) 5% 3% 9% 14%
(b) Your company should invest in Four Ltd. as it is the only investment with an IRR greater
than your company’s 9% cost of capital.
9.7 Mahmood al-Fahdui Importers Limited
(a) March 1, 2010Number of 30,000,000

shares
Share price $7.80
Market capitalization $234,000,000.00
(b) April 1, 2010

Share price $7.80
Number of rights to buy 1 share 3
Price of 3 shares before the rights issue $23.40
Price of buying 1 rights share 6.00
Value of 3 shares + 1 rights share $29.40

Chapter 9
Calculation of the theoretical ex-rights price
Value of 3 shares + 1 rights share $29.40

Number of shares (3 + 1) 4
Theoretical ex-rights price $7.35
Value of the rights offering

Price of buying 1 rights share 6.00
Price of 3 rights to buy 1 share $1.35
Number of rights needed to buy 1 share 3
Price of 1 right $0.45
(c)
(i) March 31, 2010
Share price $7.80
Number of shares 600
Value of your father’s holdings $4,680
(ii) April 1, 2010 assuming the rights are exercised.

New share price $7.35
Number of shares (600 + 200) 800
Value of share holdings $5,880.00
Less: Cost to buy new shares with the rights (200 shares × $6.00) 1,200.00
Value of holdings if rights are exercised $4,680.00
(iii) April 1, 2010, assuming the rights are sold.

New share price $7.35
Number of shares 600
Value of share holdings 4,410.00
Number of rights 600
Price of a right $0.45
Value of rights $270.00
Total value of holdings if rights are sold ($4,410 + $270) $4,680.00
(d) The value of your father’s MFIL holdings remains unaffected by the rights offering,
as long as he buys the shares or sells the rights. The value of his holdings will be
reduced if he lets the rights expire.

Chapter 9
9.8 Four Companies

(a) and (b) $ $ $ $
Price of shares before rights issue (share price x
number of shares needed to get the rights) 200.00 190.00 146.00 174.64
Price of buying the rights share 68.00 75.00 30.25 109.50
Total investment 268.00 265.00 176.25 284.14
Theoretical ex-‐rights price

Total investment $ 268.00 $ 265.00 $176.25 $ 284.14
New number of shares held 7 3 5 7
Ex-‐rights share price $ 38.29 $ 88.33 $ 35.25 $ 40.59
Difference in share price (before
rights share price
less ex-‐rights price $ 1.71 $ 6.67 $ 1.25 $ 3.07
Value of one right (difference
/number of rights
needed to buy one share) $ 0.86 $ 6.67 $ 1.25 $ 1.02
9.9 Lots of Bend Curling Supplies Limited
(a) Stock Split
November 30, 2010

Share price $25
Number of shares outstanding 1,000,000
Market capitalization $25,000,000
December 31, 2010

Number of shares outstanding after the four-for-one stock split (1 million 4,000,000
× 4)
Share price after the stock split $6.25
(b) Stock dividend of three shares per share

Number of shares outstanding after the stock dividend (1 million + 4,000,000
3 million)
$6.25

Chapter 9
(c) A four-for-one stock split and a stock dividend of three shares for each share
outstanding are basically the same thing. Both result in a $6.25 share price. The
stock dividend reduces retained earnings, however, which may affect future cash
dividends.
9.10 Four Companies


Market capitalization of the
company before the stock
dividend $400,000,000 $49,500,000 $19,800,000 $8,800,000
Number of shares outstanding
after the stock dividend 30,000,000 2,750,000 1,200,000 2,400,000
New share price
after the stock dividend
(market cap/number of shares
outstanding) $ 13.33 $ 18.00 $ 16.50 $ 3.67

Or
Stock dividend ratio
(number of new shares/
previous number of shares) 2 4 1 5
New share price
after the stock dividend
(current share price/
(1 + stock dividend ratio) $ 13.33 $ 18.00 $ 16.50 $ 3.67
9.11 EnviroCleaning Inc.

Cumulative Share Sale Proceeds ($)
Share Price ($) Number of Shares
Tendered
7.50 200,000 1,500,000

7.00 470,000 3,290,000
6.50 1,100,000 7,150,000
5.00 1,400,000 7,000,000
The striking price should be $6.50 to maximize the share sale proceeds.
9.12 The answer to this question is covered in the chapter. Refer as necessary.

Chapter 9
9.13 The answer to this question is covered in the chapter. Refer as necessary.
9.14 Smaller Businesses
This topic is covered in the chapter. Refer as necessary.
9.15 Pizza Shack Ltd.

(a) When issuing shares, establishing a share price may not be an easy task, particularly
where the market is volatile or where the business has unique characteristics. If the
share price is set too high, the issue will not sell and the business (or issuing house)
will not receive the amount expected. If the share price is set too low, the issue will
be oversubscribed and the business (or issuing house) will receive less than could
have been achieved. A tender issue avoids these problems by allowing the investors
to set the price of the shares. However, investors do not like to bid for shares in this
way and so tender issues are not widely used.
(b) (i) To issue 3 million shares, the price would have to be set at $2.80 per share. (The
cumulative number of shares at this price is 3,420,000, which is just above the
number of shares to be issued.) This will provide proceeds of $8.4M from the issue.
(ii)
Share price Number of shares tendered Cumulative number of Share
at each share price shares tendered proceeds
$ (000s) (000s) ($000s)
3.60 850 850 3,060
3.20 1,190 2,040 6,528
2.80 1,380 3,420 9,576
2.40 1,490 4,910 11,784
2.00 1,540 6,450 12,900
1.60 1,560 8,010 12,816
8,010
To maximize receipts, the shares should be sold at $2.00.

Chapter 9
9.16 Harbour Shipping Ltd.

(a)
Investment cost end

of 2009 $ 30,000,000
Less: HSL investment (5,000,000)
Less: V.C. investment (20,000,000)
Bank loan required $5,000,000
Interest (15%) for
2010 $ 750,000

2010 2011 2012 2013 2014
Operating profit $ 1,000,000 $ 1,400,000 $ 1,467,000 $ 1,678,000 $ 2,420,000
Add: Annual
depreciation
($2,000,000-‐
100,000)/10 190,000 190,000 190,000 190,000 190,000
Operating cash flow 1,190,000 1,590,000 1,657,000 1,868,000 2,610,000
Less: Additional
working capital (450,000)
Less: Interest on bank
loan (15%) (750,000) (684,000) (548,100) (449,265) (236,455)
Cash available to
repay bank loan 440,000 906,000 658,900 1,418,735 2,373,545
Bank loan at start of
year 5,000,000 4,560,000 3,654,000 2,995,100 1,576,365
Less: Bank loan
repayment (440,000) (906,000) (658,900) (1,418,735) (1,576,365)
Bank loan at end of
year 4,560,000` 3,654,000 2,995,100 1,576,365 0


Chapter 9
(b)
$ 40,000,000
Selling price of company in 5 years
Plus: excess cash ($2,373,545 -‐ $1,576,365) 797,180
Less: balance of loan repayment (0)
Less: payment to HSL (20% x $40,000,000) (8,000,000)

Amount available to VCI $ 32,797,180
Original cost to VCI $ 20,000,000
Present value factor (Original cost/Amount available after 5 years) 0.6098

The internal rate of return for this project is between 10% and 12% (10.4%) in Table A2,
for n=5 years.

(c) Therefore VCI should not undertake this investment since the project’s IRR is less than its
cost of capital of 12%.

Chapter 9
9.17 Sunrise Foods Inc.
Leasing
Present
Tax savings Value
(45% tax Payment Factor Present Value
Year Payment rate) After Tax @ 10% @ 10%
1 $394,421.33 $177,489.60 $216,931.73 0.9091 $197,212.64
2 394,421.33 177,489.60 216,931.73 0.8264 179,272.38
3 394,421.33 177,489.60 216,931.73 0.7513 162,980.81
4 394,421.33 177,489.60 216,931.73 0.6830 148,164.37
5 394,421.33 177,489.60 216,931.73 0.6209 134,692.91
6 394,421.33 177,489.60 216,931.73 0.5645 122,457.96
7 394,421.33 177,489.60 216,931.73 0.5132 111,329.36
8 394,421.33 177,489.60 216,931.73 0.4665 101,198.65
9 394,421.33 177,489.60 216,931.73 0.4241 92,000.75
10 394,421.33 177,489.60 216,931.73 0.3855 83,627.18
11 394,421.33 177,489.60 216,931.73 0.3505 76,034.57
12 394,421.33 177,489.60 216,931.73 0.3186 69,114.45
13 394,421.33 177,489.60 216,931.73 0.2897 62,845.12
14 394,421.33 177,489.60 216,931.73 0.2633 57,118.12
15 394,421.33 177,489.60 216,931.73 0.2394 51,933.46
Net present value $1,649,982.73
Buying
The loan amortization schedule is as follows:
Buying Loan Schedule
Year Opening Interest Closing

Balance Payment @ 10% Balance
1 $3,000,000.00 $394,421.33 $300,000.00 $2,905,578.67
2 2,905,578.67 394,421.33 290,557.87 2,801,715.21
3 2,801,715.21 394,421.33 280,171.52 2,687,465.40
4 2,687,465.40 394,421.33 268,746.54 2,561,790.61
5 2,561,790.61 394,421.33 256,179.06 2,423,548.34

Chapter 9
6 2,423,548.34 394,421.33 242,354.83 2,271,481.84

7 2,271,481.84 394,421.33 227,148.18 2,104,208.69
8 2,104,208.69 394,421.33 210,420.87 1,920,208.23
9 1,920,208.23 394,421.33 192,020.82 1,717,807.72
10 1,717,807.72 394,421.33 171,780.77 1,495,167.16
11 1,495,167.16 394,421.33 149,516.72 1,250,262.55
12 1,250,262.55 394,421.33 125,026.25 980,867.47
13 980,867.47 394,421.33 98,086.75 684,532.89
14 684,532.89 394,421.33 68,453.29 358,564.85
15 358,564.85 394,421.33 35,856.48 0.00
The annual CCA amounts are:
Opening
Year UCC CCA @ 10% Closing UCC
1 3,000,000.00 150,000.00 2,850,000.00

2 2,850,000.00 285,000.00 2,565,000.00
3 2,565,000.00 256,500.00 2,308,500.00
4 2,308,500.00 230,850.00 2,077,650.00
5 2,077,650.00 207,765.00 1,869,885.00
6 1,869,885.00 186,988.50 1,682,896.50
7 1,682,896.50 168,289.65 1,514,606.85
8 1,514,606.85 151,460.68 1,363,146.17
9 1,363,146.17 136,314.62 1,226,831.55
10 1,226,831.55 122,683.16 1,104,148.39
11 1,104,148.39 110,414.84 993,733.55
12 993,733.55 99,373.35 894,360.20
13 894,360.20 89,436.02 804,924.18
14 804,924.18 80,492.42 724,431.76
15 724,431.76 72,443.18 651,988.58

Chapter 9
The annual tax shields are:
Interest @ Total Tax Shield @

Year 10% CCA @ 10% Deductions 45%
1 300,000.00 150,000.00 450,000.00 202,500.00

2 290,557.87 285,000.00 575,557.87 259,001.04
3 280,171.52 256,500.00 536,671.52 241,502.18
4 268,746.54 230,850.00 499,596.54 224,818.44
5 256,179.06 207,765.00 463,944.06 208,774.83
6 242,354.83 186,988.50 429,343.33 193,204.50
7 227,148.18 168,289.65 395,437.83 177,947.02
8 210,420.87 151,460.68 361,881.55 162,846.70
9 192,020.82 136,314.62 328,335.44 147,750.95
10 171,780.77 122,683.16 294,463.93 132,508.77
11 149,516.72 110,414.84 259,931.56 116,969.20
12 125,026.25 99,373.35 224,399.60 100,979.82
13 98,086.75 89,436.02 187,522.77 84,385.25
14 68,453.29 80,492.42 148,945.71 67,025.57
15 35,856.48 72,443.18 108,299.66 48,734.85
Buying
Present
Tax Shield Value
(45% tax Net Cost Factor Present Value
Year Payment rate) of Buying @ 10% @ 10%
1 $394,421.33 $202,500.00 $191,921.33 0.9091 $174,475.68
2 394,421.33 259,001.04 135,420.29 0.8264 111,911.33
3 394,421.33 241,502.18 152,919.15 0.7513 114,888.16
4 394,421.33 224,818.44 169,602.89 0.6830 115,838.77
5 394,421.33 208,774.83 185,646.50 0.6209 115,267.91
6 394,421.33 193,204.50 201,216.83 0.5645 113,586.90
7 394,421.33 177,947.02 216,474.31 0.5132 111,094.62
8 394,421.33 162,846.70 231,574.63 0.4665 108,029.56
9 394,421.33 147,750.95 246,670.38 0.4241 104,612.91
10 394,421.33 132,508.77 261,912.56 0.3855 100,967.29
11 394,421.33 116,969.20 277,452.13 0.3505 97,246.97
12 394,421.33 100,979.82 293,441.51 0.3186 93,490.47

Chapter 9
13 394,421.33 84,385.25 310,036.08 0.2897 89,817.45

14 394,421.33 67,025.57 327,395.76 0.2633 86,203.30
15 394,421.33 48,734.85 345,686.48 0.2394 82,757.34
Net present value $1,620,188.66

Cheaper to buy by: $29,794.07
It is less expensive to buy the warehouse than to lease it.
9.21 Fanverse Athletic Shoes
(a) The loan amortization schedule is:

Beginning Interest Ending
Year Balance Payment @ 5% Balance
1 $162,156.43 $20,000.00 $ -‐ $142,156.43
2 142,156.43 20,000.00 7,107.83 129,264.26
3 129,264.26 20,000.00 6,463.21 115,727.47
4 115,727.47 20,000.00 5,786.37 101,513.84
5 101,513.84 20,000.00 5,075.69 86,589.53
6 86,589.53 20,000.00 4,329.48 70,919.01
7 70,919.01 20,000.00 3,545.95 54,464.96
8 54,464.96 20,000.00 2,723.25 37,188.21
9 37,188.21 20,000.00 1,859.41 19,047.62
10 19,047.62 20,000.00 952.38 (0.00)

(b) The 10-‐year CCA schedule is:
Beginning CCA Ending

Year UCC @30% UCC
1 $162,156.43 $24,323.46 $137,832.97
2 137,832.97 41,349.89 96,483.08
3 96,483.08 28,944.92 67,538.16
4 67,538.16 20,261.45 47,276.71
5 47,276.71 14,183.01 33,093.70
6 33,093.70 9,928.11 23,165.59
7 23,165.59 6,949.68 16,215.91
8 16,215.91 4,864.77 11,351.14
9 11,351.14 3,405.34 7,945.80
10 7,945.80 2,383.74 5,562.06


Chapter 9
(c) The ten year tax shield schedule for the purchase option is:
Interest CCA Total Tax Shield

Year @ 5% @ 30% Deductions (40% tax rate)
1 0.00 24,323.46 24,323.46 9,729.38
2 7,107.83 41,349.89 48,457.72 19,383.09
3 6,463.21 28,944.92 35,408.13 14,163.25
4 5,786.37 20,261.45 26,047.82 10,419.13
5 5,075.69 14,183.01 19,258.70 7,703.48
6 4,329.48 9,928.11 14,257.59 5,703.04
7 3,545.95 6,949.68 10,495.63 4,198.25
8 2,723.25 4,864.77 7,588.02 3,035.21
9 1,859.41 3,405.34 5,264.75 2,105.90
10 952.38 2,383.74 3,336.12 1,334.45

(d) The after-‐tax net present value of the purchase option is $93,736.75 as shown below.
Buying
Tax Shield Net Cost Present Value Present Value

Year Payment (40% tax rate) of Buying Factor @ 5% @ 5%
1 $20,000.00 $9,729.38 $10,270.62 1.0000 $10,270.62
2 20,000.00 19,383.08 616.92 0.9524 587.55
3 20,000.00 14,163.25 5,836.75 0.9070 5,293.93
4 20,000.00 10,419.13 9,580.87 0.8638 8,275.96
5 20,000.00 7,703.48 12,296.52 0.8227 10,116.35
6 20,000.00 5,703.04 14,296.96 0.7835 11,201.67
7 20,000.00 4,198.25 15,801.75 0.7462 11,791.27
8 20,000.00 3,035.21 16,964.79 0.7107 12,056.88
9 20,000.00 2,105.90 17,894.10 0.6768 12,110.73
10 20,000.00 1,334.45 18,665.55 0.6446 12,031.81
Net present value after tax $93,736.77
(e)
Leasing
Tax savings Payment Present Value Present Value

Year Payment (40% tax rate) after tax Factor @ 5% @ 5%
1 $20,000.00 $8,000.00 $12,000.00 1.0000 $12,000.00
2 20,000.00 8,000.00 12,000.00 0.9524 11,428.80
3 20,000.00 8,000.00 12,000.00 0.9070 10,884.00
4 20,000.00 8,000.00 12,000.00 0.8638 10,365.60
5 20,000.00 8,000.00 12,000.00 0.8227 9,872.40
6 20,000.00 8,000.00 12,000.00 0.7835 9,402.00

Chapter 9
7 20,000.00 8,000.00 12,000.00 0.7462 8,954.40

8 20,000.00 8,000.00 12,000.00 0.7107 8,528.40
9 20,000.00 8,000.00 12,000.00 0.6768 8,121.60
10 20,000.00 8,000.00 12,000.00 0.6446 7,735.20
Net present value after tax $97,292.40

(f) Purchasing is better because it would save FAS $3,555.63.

Chapter 9
Solutions to Additional Problems and Cases
A-9.1 Western Ltd.
(a) (i) Earnings per share for each financing option, and under each scenario, is as follows:
Loan issue
Scenario
Optimistic Most likely Pessimistic
$m $m $m
Earnings before interest and taxation 10.4 8.8 6.4
Interest (2.4 + 1.5) 3.9 3.9 3.9
Earnings before tax 6.5 4.9 2.5
Income tax (30%) 2.0 1.5 0.8
Net income 4.5 3.4 1.7
Dividend paid 1.2 1.2 1.2
Increase in retained earnings 3.3 2.2 0.5
EPS $4.5m/40m $3.4m/40m $1.7m/40m
$0.113 $0.085 $0.043
Rights issue
Scenario
$m $m $m
Earnings before interest and taxation 10.4 8.8 6.4
Interest 2.4 2.4 2.4
Earnings before tax 8.0 6.4 4.0
Income tax (30%) 2.4 1.9 1.2
Net income 5.6 4.5 2.8
Dividend paid 1.5 1.5 1.5
Increase in retained earnings 4.1 3.0 1.3
EPS $5.6m/50m $4.5m/50m $2.8m/50m
$0.112 $0.090 $0.056

Chapter 9
(ii) Leverage ratios

Loan issue
Scenario
$m $m $m
35/(20 + 39 + 15 + 3.3)] [35/(20 + 39 + 15 + 2.2)] [35/(20 + 39 + 15 + 0.5)]
× 100% × 100% × 100%
= 45.3% = 45.9% = 47.0%
Rights issue
Scenario
$m $m $m
[20/(20 + 39 + 15 + 4.1)] [20/(20 + 39 + 15 + 3.0)] [20/(20 + 39 + 15 + 1.3)]
× 100% × 100% × 100%
= 25.6% = 26.0% = 26.6%
(iii) Times interest earned ratios

Loan issue
Scenario
Earnings before interest and tax 10.4 8.8 6.4
Interest expense 3.9 3.9 3.9
Times interest earned 2.7 times 2.3 times 1.6 times
Rights issue
Scenario
Earnings before interest and tax 10.4 8.8 6.4
Interest expense 2.4 2.4 2.4
Times interest earned 4.3 times 3.7 times 2.7 times
(b) We can see from the above that the leverage effect on returns is very small. There are only
modest variations in return to common shareholders between the rights option and the loan
option. However, the loan option does result in much higher leverage ratios and this will
have an effect on the debt capacity of the business. In addition, the times interest earned ratio
is significantly lower under the loan option. As the additional financial risk, revealed by
these ratios, is not reflected in higher returns to shareholders, more borrowing does not
appear to be an attractive option.

Chapter 9
The existing EPS is $0.098 (that is, $3.9m/40m) and this is higher than the EPS forecasts for
the most likely and pessimistic scenarios. The existing leverage ratio of 33.9 per cent
[20m/(20m + 39m)] falls between the leverage ratios under the equity option and the loan
option. The existing times interest earned ratio of 3.3 times (8.0m ÷ 2.4m) is higher than all
scenarios under the loan issue option and the pessimistic scenario for the rights issue.
The calculations above do not reveal a compelling case for the expansion program.
A-9.2 Devon Ltd.
(a) (i) Ex-rights price

$
5 original shares @ $2.10 per share 10.50
1 rights share @ $1.80 1.80
12.30
Theoretical ex-rights price ($12.30/6) $2.05
(ii) Value of rights
$
Value of a share after the rights issue 2.05
Cost of a rights share 1.80
Value of rights 0.25
Value of rights attached to each original share $0.25/5
$0.05
(b) (i) Share price in one year’s time
Rights issue
We must first calculate the existing P/E ratio in order to determine the share price in one
year’s time. This can be done as follows:
$m
Earnings before interest and taxes (2010) 40.0
Less Income tax (30%) 12.0
Earnings available to shareholders 28.0
Earnings per share (EPS) ($28.0m/200m) = $0.14
Share price
P/E ratio =
EPS
= $2.10/$0.14
= 15 times

Chapter 9
$m
Earnings before interest and taxes (2011) 50.0[40m + (25% × 40m)]
Earnings per share ($35m/240m) = $0.146
Share price = EPS × P/E ratio*
= $0.146 × 15
= $2.19
* This is a rearrangement of the PE ratio formula shown above.
(ii) Loan issue

$m
Earnings before interest and taxes profit (2011) 50.0
Less Loan interest payable ($72m @ 10%) 7.2
42.8
Earnings per share $30m/200m = $0.15
Share price = EPS × P/E ratio
= $0.15 × 13.5
= $2.03
The above calculations reveal that in one year’s time the share price is expected to rise by
more than 4 per cent above the current share price if a rights issue is made, whereas the share
price will fall by more than 3 per cent if a loan issue is made.
Given the additional financial risks attached to a loan issue, it seems that a rights issue offers
the better alternative — at least in the short term.
(c) and (d) These topics are covered in the chapter. Review as necessary.

Chapter 9
A-9.3 Carpets Direct Ltd.
(a) The stages in calculating the theoretical ex-rights price of a common share are as
follows:
Earnings per share
Net income $4.5 million

= = $0.0375
Number of shares 120 million
Market value per share
Earnings per share × P/E ratio = $0.0375 × 22 = $0.825
For the theoretical ex-rights price:
($)
Original shares (4 × $0.825) 3.30
Rights share (100% – 20%) × $0.825 0.66
Value of five shares following rights issue 3.96
Value of one share following the rights issue $3.96
5
(b) The price at which the rights are likely to be traded is:
($)
Value of one share after rights issue 0.792
Less: Cost of a rights share 0.660
Value of rights to shareholder 0.132
(c) Comparing the three options open to the investor:
Option 1: Using the rights to buy shares
($)
Shareholding following rights issue [(4,000 + 1,000) × $0.792] 3,960
Less: Cost of rights shares (1,000 × $0.660) 660
Shareholder wealth 3,300

Chapter 9
Option 2: Selling the rights
Shareholding following rights issue (4,000 × $0.792) 3,168

Add: Proceeds from sale of rights (1,000 × $0.132) 132
Shareholder wealth 3,300
Option 3: Doing nothing
If the rights are neither purchased nor sold, the shareholder wealth following the rights
issue will be:
Shareholding (4,000 × $0.792) 3,168
The investor will have the same wealth under the first two options. However, if the
investor does nothing, the rights issue will lapse and so the investor will lose the value of
the rights and will be worse off.

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Chapter 9

Financing a Business 2: Raising Long-Term Funds

Answers to Review Questions

Copyright © 2012 Pearson Canada Inc. 178

9.4 A business should have owners who are:

• Committed to realizing the growth potential of the business

A business should have a management team that is:

Solutions to Problems and Cases

1. Semi-strong form of market efficiency - because the formal announcement led to

4. Semi-strong form of market efficiency - because the formal announcement led to

Copyright © 2012 Pearson Canada Inc. 179

9.3 ETF Investments

Sector Now 1 Year Ago % Increase

9.4 J. Muserandathon Portfolio

Year J. Muserandathon S&P/TSX Composite %

Copyright © 2012 Pearson Canada Inc. 180

9.5 Your Company

A Ltd. B Ltd. C Ltd. D Ltd.

9.6 Your Company

One Ltd. Two Ltd. Three Ltd. Four Ltd.

9.7 Mahmood al-Fahdui Importers Limited

(a) March 1, 2010Number of 30,000,000

(b) April 1, 2010

Copyright © 2012 Pearson Canada Inc. 181

Calculation of the theoretical ex-rights price

Value of 3 shares + 1 rights share $29.40

Value of the rights offering

(ii) April 1, 2010 assuming the rights are exercised.

(iii) April 1, 2010, assuming the rights are sold.

Total value of holdings if rights are sold ($4,410 + $270) $4,680.00

Copyright © 2012 Pearson Canada Inc. 182

9.8 Four Companies

A Ltd. B Ltd. C Ltd. D Ltd.

Theoretical ex-­‐rights price

9.9 Lots of Bend Curling Supplies Limited

(a) Stock Split

November 30, 2010

December 31, 2010

(b) Stock dividend of three shares per share

Copyright © 2012 Pearson Canada Inc. 183

9.10 Four Companies

9.11 EnviroCleaning Inc.

7.50 200,000 1,500,000

Copyright © 2012 Pearson Canada Inc. 184

9.14 Smaller Businesses

This topic is covered in the chapter. Refer as necessary.

9.15 Pizza Shack Ltd.

Copyright © 2012 Pearson Canada Inc. 185

9.16 Harbour Shipping Ltd.

Investment cost end

Copyright © 2012 Pearson Canada Inc. 186

Plus: excess cash ($2,373,545 -­‐ $1,576,365) 797,180

Less: balance of loan repayment (0)

Less: payment to HSL (20% x $40,000,000) (8,000,000)

Present value factor (Original cost/Amount available after 5 years) 0.6098

Copyright © 2012 Pearson Canada Inc. 187

9.17 Sunrise Foods Inc.

The loan amortization schedule is as follows:

Buying Loan Schedule

Year Opening Interest Closing

Copyright © 2012 Pearson Canada Inc. 188

6 2,423,548.34 394,421.33 242,354.83 2,271,481.84

The annual CCA amounts are:

Theoretical ex-‐rights price

Plus: excess cash ($2,373,545 -‐ $1,576,365) 797,180