AG985 / AG993 WORKSHOP 2

Please note that some of these questions are included for additional work but are not
expected to be covered during the tutorial session. The tutorial will focus on Qs 1, 2, and 4.
Solutions will be provided to all questions. Since rights offers involve a proof that wealth is
equal there are a number of different approaches to proving this. Solutions to Q3 are
presented in an alternative format to demonstrate this. Students can use any appropriate
method they wish.

Question 1
Serengeti plc has 100million shares outstanding trading at a price of £2.00 per share. The
firm believes it has identified a profitable investment project that will require £50million to
invest in. The company decides to raise equity through a rights offering to fund the
expansion project. The shares will be sold at a 20% discount to the current market price.
The firm expects to generate net income after tax of £40million per year following
investment in the project.

a) Devise the terms of the rights offer and calculate the theoretical ex-rights price and
the value of a right to purchase one new share.

PS = £2.00 x (1 – 0.20) = £1.60

N* = £50m / £1.60 = 31.25million shares
N* / N = 31.25 / 100 = 5 for 16
Px = (£200m + £50m) / 131.25 = £1.9048
Px – Ps = £1.9048 - £1.60 = £0.3048

b) Show that in theory an investor holding 160 shares will be equally well off irrespective
of whether they take up their rights or sell the rights.

Take up rights:
Investor owns 160 shares @ P0 = £320
Purchase 50 shares @ PS = £80
Cost of portfolio = £400
Value of portfolio, owns 210 shares @ Px = £400

Sell rights:
Investor owns 160 shares @ P0 = £320
Sells rights to purchase 50 shares @ Px – Ps = -£15.2381
Cost of portfolio = £304.7619
Value of portfolio, owns 160 shares @ Px = £304.7619

c) Rather than issuing shares at a 20% discount, the firm decides to issue at a deep
discount of 50% to the current market share price. Re-estimate the terms of the
rights offer.

PS = £2.00 x (1 – 0.50) = £1.00

N* = £50m / £1.00 = 50million shares
N* / N = 50 / 100 = 1 for 2
Px = (£200m + £50m) / 150 = £1.6667
Px – Ps = £1.6667 - £1.00 = £0.6667

d) Calculate the earnings per share and earnings yield under both a 20% discount and
50% discount and comment on the view that deep discounted rights offers are
unattractive because they reduce earnings per share.

Conventional Discount Deep Discount

Profit after tax £40m £40m
No of shares 131.25m 150m
EPS £0.3048 £0.2667

Earnings yield:

Conventional discount = E/P = £0.3048/£1.9048 = 0.16

Deep discount = E/P = £0.2667/£1.6667 = 0.16

Deep discounted rights offers do reduce earnings per share as can be seen above. However,
this is misleading and reflects the lower initial investment cost of the share. After adjusting
for this through the lower ex-rights price we can see that the yield or return relative to the
initial investment is the same irrespective of the discount on the share.
Question 2
As the financial manager of Charlie’s Dog Food Plc, a UK company listed on the London Stock
Exchange (LSE), you have been asked to evaluate the company’s options with regards to a
new equity offering. Charlie’s Dog Food currently has 100million shares in issue at a current
market price of 100p per share. The company plans to raise £50million of new equity. The
company’s merchant bank has put forward the following proposals to the board:

i. A rights offering at a 20% discount to the current market price.

ii. A deep-discounted rights offering at a 60% to the current market price.
iii. A share placing at a 5% discount to the current market price.

a) Set out the terms of the rights offering for i, and ii, and the public offering in iii. Your
answer should state the cum-price, the number of new shares to be issued and
rights price, the theoretical ex-rights price, the exchange ratio, and the value of the
right to purchase one new share. The equivalent terms for the public offering should
also be stated.

i. Cum price = £1.00

Rights price = £1.00 * (1 – 0.20) = £0.80
Number of new shares = £50,000,000 / £0.80 = 62,500,000 shares
TERP = (£100m + £50m)/162,500,000 = £0.9231
Ratio of new shares to old = 62.5 / 100 = 5 for 8
Value of a right = £0.9231 - £0.80 = £0.1231

ii. Cum price = £1.00

Rights price = £1.00 * (1 – 0.60) = £0.40
Number of new shares = £50,000,000 / £0.40 = 125,000,000 shares
TERP = (£100m + £50m)/225,000,000 = £0.6667
Ratio of new shares to old = 125 / 100 = 5 for 4
Value of a right = £0.6667 - £0.40 = £0.2667

iii. Pre-offer price = £1.00

Offer price = £1.00 * (1 – 0.05) = £0.95
Number of new shares = £50,000,000 / £0.95 = 52,631,579 shares
After offer share price = (£100m + £50m)/152,631,579 = £0.9828

b) For options ii and iii above show how the wealth of an investor with 20,000 shares in
the company will be affected by the offer characteristics. In the case of the rights
offer you should highlight how investor wealth is unaffected by the decision to take
up or sell their rights in the offering.

ii.
Take-up rights:
Owns 20,000 shares @ £1.00 = £20,000
Right to buy 25,000 shares @ £0.40 = £10,000
Total investment = £30,000
Shares worth 45,000 @ £0.6667 = £30,000
Net wealth unaffected

Sell right:
Owns 20,000 shares @ £1.00 = £20,000
Sell rights to buy 25,000 shares @ £0.2667 = £6,666.67
Total investment = £13,333.33
Shares worth 20,000 @ £0.6667 = £13,333.33
Net wealth unaffected

iii.
Owns 20,000 shares @ £1.00 = £20,000
Now worth 20,000 @ £0.9828 = £19,655.17
Loss in wealth = £344.83
Question 3
JJ Plc’s is a small retail banking firm, whose share price has declined during the global
financial crisis since mid-2007 from a high of 1,200pence per share. The stock is currently
trading at a price of 400pence and the company has 50million shares in issue. The company
plans to announce a rights issue tomorrow to raise £100million to eliminate the company’s
debt, given fears over investor’s attitudes to debt and the company’s financial stability
during the credit crunch. The financial restructuring will also aid the company to comply
with the recently announced Basel III recommendations in advance of the required date in
several years time.

Given high uncertainty in the banking industry at present, it is proposed that JJ Plc will
require having the issue underwritten and offered at a 50% discount to the current market
price. Since the new issue is being carried out to reduce debt, it is not expected to have any
impact on the expected earnings before interest and taxes (EBIT), which is forecast at
£25million for the forthcoming financial year-end. The company currently has £100million
in borrowings paying a fixed interest rate of 7%.

As the finance director of the company you have been asked to provide the following
information to the company’s board of directors:

a) Specify the terms of the rights offering; covering the subscription price of the new
issue, the number of new shares to be offered, the exchange ratio, the theoretical
ex-rights price and the value of a right to buy one new share.

Cum price £4.00

Discount 50.00%
Rights price £2.0000
£100,000,000.
F 00
N 50,000,000
ΔN 50,000,000
rB 7.00%
TERP £3.0000
Value of a right £1.0000
Exchange ratio,
1 for 1

b) Show that in principle the wealth of an investor who owns 50,000 shares prior to the
issue will be unaffected by either subscribing to the rights, selling the rights nil-paid,
or selling enough rights to fund the purchase of a maximum number of shares with
no further cash investment (tail-swallowing). Briefly comment on your findings.

Investor owns 50000 shares £200,000.00

Take-up rights
 Buy 50000 shares @ 200p, Gain TERP - Rights £50,000.00
Own 50000 shares, Lose Cum Price - TERP -£50,000.00
Net gain / loss from taking up
rights £0.00

Sell rights
Sell rights to buy 50000 shares @
100p £50,000.00
Own 50000 shares, Lose Cum Price - TERP -£50,000.00
Net gain / loss from selling rights nil-paid £0.00

Tail swallowing
Sell Y rights, where Y = (Ps x N*)/Px 33,333.33
Take up N* - Y rights 16,666.67

Buy 16,666.66 shares @ 200, Gain TERP - Rights £16,666.67

Sell rights to buy 33,333.33 shares @ 100p £33,333.33
Own 50000 shares, Lose Cum Price - TERP -£50,000.00
Net gain / loss from tail swallowing £0.00

Note the solution to this question uses a different format where the workings emphasise the
capital gain / capital loss on new shares / existing shares. Both methods are equally
appropriate and presented to make you aware of alternative methods of analysing investor
wealth effects of rights offerings.
Question 4
Hicks plc is expected to generate earnings before interest and tax of £80 million in perpetuity.
It is an all equity financed company. Following discussions with the company's merchant bank
a proposal for financial restructuring is under consideration. It has been suggested that the
company raise £150 million through an issue of debentures paying an annual interest rate of 8
per cent, and to use the proceeds to buy back shares at the current market price. With a
corporate tax rate of 25 per cent the cost of debt is believed to be well below that of equity.
The company has 400 million shares outstanding and the share price is currently £1.00.

a) Determine the expected EPS for the company before and after the proposed
restructuring, and level of earnings before interest and tax at which the EPS would
be the same for the alternative capital structures.

U G
EBIT 80 80
Interest 0 -12
PBT 80 68
Tax -20 -17
PAT 60 51
No of shares 400m 250m
EPS £0.1500 £0.2040

EBIT* (1 – Tc)/(N(U) = (EBIT* - Int) (1 – Tc)/N(G)

*
EBIT /400 = (EBIT* - 12)/250
250 EBIT* = 400 EBIT* - 4800
EBIT* = 4800 / 150
*
EBIT = 32m
EPS = £32m * (1 – 0.25) / 400million = £0.06
EPS = (£32m - £12m) * (1 – 0.25) / 250million = £0.06

b) With reference to the calculations above, explain why earnings per share is higher for
the geared scenario but why this does not mean that shareholder’s wealth will be
increased or decreased.

Expected earnings per share should increase in the geared scenario to reflect compensation
for risk, without necessarily implying higher shareholder value. If expected earnings are
greater than the break even value of £32 million then shareholders benefit from debt, but
they will experience lower EPS in the event that earnings turn out to be lower than £32m.
Corporate taxes create an additional benefit to debt (beyond the risk explanation) but again
this tax benefit is conditional on the ability of the firm to generate a taxable profit.

After further deliberation, Hicks Plc decides to abandon the capital restructuring and
believes it has identified a profitable investment project that will require £100million of
equity to fund the investment. The company decides to raise equity through a rights
offering to fund the expansion project. The shares will be sold at a 20 per cent discount to
the current market price of £1.00 per share.
 c) Devise the terms of the rights offer and calculate the theoretical ex-rights price and
the value of a right to purchase one new share.

PS = £1.00 x (1 – 0.20) = £0.80

N* = £100m / £0.80 = 125 million shares
N* / N = 125 / 400 = 5 for 16
Px = (£400m + £100m) / 400m + 125m = £0.9523
Px – Ps = £0.9523 - £0.80 = £0.1523

d) Show that in theory an investor holding 320 shares will be equally well off irrespective
of whether they take up their rights, sell the rights, or tail swallow (sell off rights to
fund the purchase of the maximum number of additional share with no new
investment).

Take up rights:
Investor owns 320 shares @ P0 = £320
Purchase 100 shares @ PS = £80
Cost of portfolio = £400
Value of portfolio, owns 420 shares @ Px = £400

Sell rights:
Investor owns 320 shares @ P0 = £320
Sells rights to purchase 100 shares @ Px – Ps = -£15.24
Cost of portfolio = £304.76
Value of portfolio, owns 320 shares @ Px = £304.76

e) Based on your workings above explain the principle that rights offerings protect the
wealth of shareholders.

 Rights offers allow shareholders to purchase shares at a discounted subscription

price below the current subscription price of the firm’s shares;
 Shareholders suffer a loss on wealth as the share price drops from the current
market price to the ex-rights price;
 This is offset by either the capital gain on taking up rights or the income from selling
rights.
Question 5
As the financial manager of Baird Plc you have been asked to evaluate the company’s
options with regards to a new equity offering. The company has experienced a decline in
revenue in 2020 and 2021 during the economic crisis but the directors believe that the firm
has a long-term sustainable business model that will be successful once the economy
rebounds.

Baird Plc currently has 250million shares in issue at a current market price of 75p per share.
The company plans to raise £125million of new equity. The company’s investment bank has
put forward the following proposals to the board:

i. A rights offering at a 1/3 discount to the current market price.

ii. A deep-discounted rights offering at a 60 per cent discount to the current market
price.

Baird Plc’s management is leaning towards using the deep discounted rights offering due to
the poor financial market conditions the company has experienced over the past two years.
However, the board of directors is concerned about the potential dilutive effect of the
offering on the firm’s earnings per share (EPS). Once business conditions return to normal,
the firm expects to generate long-term net income after-tax of £50m per annum.

a) Set out the terms of the rights offering for i, and ii.

i. Cum price = £0.75

Rights price = £0.75 * (1 – 0.3333) = £0.50
Number of new shares = £125m / £0.50 = 250,000,000 shares
Ratio of new shares to old = 250 / 250 = 1 for 1
TERP = (£187.5m + £125m) / 500,000,000 = £0.6250
Value of a right = £0.6250 - £0.50 = £0.1250

ii. Cum price = £0.75

Rights price = £0.75 * (1 – 0.60) = £0.30
Number of new shares = £125,000,000 / £0.30 = 416.67 shares
Ratio of new shares to old = 416.67 / 250 = 5 for 3
TERP = (£187.5m + £125m) / 666,666,667 = £0.46875
Value of a right = £0.46875 - £0.30 = £0.16875

b) Use the earnings per share and earnings yield calculations to determine whether the
deep discounted offering is dilutive to EPS and shareholder’s wealth.

1/3 percent discount 60 percent discount

Net income 50 50
No. shares 500 666.67
EPS 0.1000 0.075

Earnings yield:
Conventional discount = E/P = £0.1000/£0.6250 = 0.16
Deep discount = E/P = £0.0750/£0.46875 = 0.16

Deep discounted rights offers do reduce earnings per share as can be seen above. However,
this is misleading and reflects the lower initial investment cost of the share. After adjusting
for this through the lower ex-rights price we can see that the yield or return relative to the
initial investment is the same irrespective of the discount on the share.

c) Explain why the company may prefer a deep discounted offering during a period of
financial market volatility and a downturn following the recent global pandemic.

Deep discounting can be attractive when the issuing firm is concerned about the stock price
of the firm decreasing below the subscription / rights price for the offering in the period
between the announcement of the offer and the shares trading ex-rights. A deep discount
gives more room for the share price to fall but for the value of a right to remain positive. If
P0 > Ps then Px > Ps and the deep discounted offering increases the probability of this being
the case.