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.

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.

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.

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.
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.

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.
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.

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.
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.

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.

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.

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).

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

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.

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.