4 (a) Theoretical ex rights price
Rights issue price = 7·50 x 0·8 = $6·00 per share
Number of shares issued = $90m/6·00 = 15 million shares
Number of shares currently in issue = 60 million shares
The rights issue is on a 1 for 4 basis
Theoretical ex rights price = ((4 x 7·50) + (1 x 6·00))/5 = $7·20 per share
Alternatively, theoretical ex rights price = ((60m x 7·50) + (15m x 6·00))/75m = $7·20 per share, where 75 million is the
number of shares after the rights issue.
(b) Financial acceptability to shareholders of buying back bonds
The financial acceptability to shareholders of the proposal to buy back bonds can be assessed by calculating whether
shareholder wealth is increased or decreased as a result.
The bonds are being bought back by Bar Co at their market value of $112·50 per bond, rather than their nominal value of
$100 per bond. The total nominal value of the bonds redeemed will therefore be less than the $90 million spent redeeming
them.
Nominal value of bonds redeemed = 90m x (100/112·50) = $80 million
Interest saved by redeeming bonds = 80m x 0·08 = $6·4 million per year
Earnings per share will be affected by the redemption of the bonds and the issue of new shares.
Revised profit before tax = 49m – (10m – 6·4m) = $45·4 million
Revised profit after tax (earnings) = 45·4m x 0·7 = $31·78 million
Revised earnings per share = 100 x (31·78m/75m) = 42·37 cents per share
15Current earnings per share = 100 x (27m/60m) = 45 cents per share
Current price/earnings ratio = 750/45 = 16·7 times
The revised earnings per share can be used to calculate a revised share price if the price/earnings ratio is assumed to be
constant.
Revised share price = 16·7 x 42·37 = 708 cents or $7·08 per share
This share price is less than the theoretical ex rights price per share ($7·20) and so the effect of using the rights issue funds
to redeem the bonds is to decrease shareholder wealth. From a shareholder perspective, therefore, this use of the funds cannot
be recommended.
However, this conclusion depends heavily on the assumption that the price/earnings ratio remains constant, as this ratio was
used to calculate the revised share price from the revised earning per share. In reality, the share price after the redemption
of bonds will be set by the capital market and it is this market-determined share price that will determine the price/earnings
ratio, rather than the price/earnings ratio determining the share price. Since the financial risk of Bar Co has decreased
following the redemption of bonds, the cost of equity is likely to fall and the share price is likely to rise, leading to a higher
price/earnings ratio. If the share price increases to above the theoretical ex rights price per share, corresponding to an increase
in the price/earnings ratio to more than 17 times (720/42·37), shareholders will experience a capital gain and so using the
cash raised by the rights issue to buy back bonds will become financially acceptable from their perspective.
(c) Current interest coverage ratio = 49m/10m = 4·9 times
Revised interest coverage ratio = 49m/(10m – 6·4m) = 49m/3·6m = 13·6 times
Current debt/equity ratio = 100 x (125m/140m) = 89%
Revised book value of bonds = 125m – 80m = $45 million
Revised book value of equity = 140m + 90m – 10m = $220 million
A loss of $10 million is deducted here because $90 million has been spent to redeem bonds with a total nominal value (book
value) of $80 million.
Revised debt/equity ratio = 100 x (45m/220m) = 20·5%
