Business Finance
ACCA Director 
Business Finance
Business Finance
Sketch
This chapter focuses on both short term and long term sources of finance.
Sources of short term finance
Overdraft:
- Overdrafts are subject to an agreed limit set by banks.
- Overdraft shows a credit balance in the bank account, ie a short term liability.
- Customers only pay interest based on the amount overdrawn.
Advantages |
Disadvantages |
No impact on long term financial gearing ratio |
Repayable on demand |
Relatively cheap if overdrawn for a short period of time |
Quite expensive if overdrawn for a long period of time |
Short-term loan:
- The amount of loan available depends on the quality of asset being used as security.
- Interest is paid based on the full amount of short term loan rather than the amount used by the business.
- Loan repayment each period = Amount borrowed / Annuity factor
Advantages |
Disadvantages |
Better cash flows planning as interests and repayment are known |
Usually, affect gearing ratio calculation |
A gain to the business if a fixed interest rate loan is applied when there is an increase in interest rate |
A loss to the business if a fixed interest rate loan is applied when there is a decrease in interest rate |
Illustrated example: Calculate the repayment for each period if a business borrows $100,000 for a period of 3 years at an interest rate of 5% per year. Comment: Repayment each year = Amount borrowed/Annuity factor = $100,000/2.723 = $36,724
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Trade credit:
- This could be the amount owed to suppliers, ie trade payables.
- This could also be proceeds received from customers in advance.
- Trade credit is usually interest-free if it is still within the credit period.
Advantage |
Disadvantage |
Cheap sources of finance. |
Worsen relationship with suppliers if there are significant delays settling the invoice. |
Leases:
- A lease is to rent an asset either on a short or long term basis instead of buying it.
- A lessee could also sell an asset and then lease it back from the buyer, ie to obtain cash without interrupting its use.
Advantages |
Disadvantages |
Lessee could usually cancel the lease with short notice, ie flexible. |
Lessor may also have the power to terminate the lease with short notice. |
Lessee does not need to commit itself like applying for a loan, ie do not require assets to be used as securities. |
Terms in the lease agreement may change, ie to inflate the rental payment. |
Total interest paid may be far less than the loan. |
Higher rent in short term leases compared to long term leases. |
Short term leases may be hidden from the balance sheet, ie off-balance sheet finance. |
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No covenants, ie flexibility in business spending decisions. |
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Tax saved on rental expenses – additional cash inflows. |
Sources of long-term debt finance
Characteristics of long-term debt finance:
- Costs - Lower than equity finance, ie tax savings on interest and reduced administration costs.
- Control - No dilution of controls in the business.
- Gearing - Worsen gearing as more long-term debt is used.
Types of long term debt finance:
- Deep discount bonds – bonds with a large discount to its face value with low-interest payment.
- Zero coupon bonds – bonds with large discount to its face value with no interest payment.
- Convertible bonds – bonds give a right to the holder to convert into shares at a predetermined time and price.
- Market value – the price they are traded in the market. The initial price is the present value of future interest and redemption payments where subsequently, the price will also subject to supply and demand of traders in the market. Pre-tax costs of borrowing should be used in the calculation.
- Lower interest rate – businesses may issue convertible bonds to benefit from the lower interest payments than conventional bonds as convertible bonds offer additional rights to convert into shares.
- Floor value – cash redemption value. This is the minimum price calculated as the present value of future interest payment and redemption value without the conversion option. The rights to convert into shares will not be exercised if the market value is less than the floor value.
- Conversion premium – difference between market value of convertible bonds and market value of convertible shares. Issuers try to maximise the conversion premium whereas investors may be cautious to those convertibles with high conversion premium as it implies those convertibles may take longer to breakeven.
- Conversion ratio – number of shares that a convertible bond could be converted into. For example, 50:1 means one $1,000 convertible bond can be converted into 50 shares.
- Redemption value – should be the higher of conversion value (expected share value) and cash redemption value.
Case Study - Nio
In 2018, a Chinese car company Nio was successfully listed in New York Stock Exchange. However, its financial performance has worsened, as the competitor, Tesla plans to deliver its vehicles from a new factory in Shanghai. In late September, Nio reported a loss of Rmb3.3bn ($462m) for the three months to the end of June in its interim report whilst its convertible bond drops significantly.
Illustrated question (Convertibles): Each $1,000 convertible can be converted into 50 shares. Coupon rate is 8%. Pre-tax costs of borrowing is 6%. Tax rate is 30%. Any bonds not converted will be redeemed at $1,100 cash after three years. Required: Calculate the market value of convertible bond if the share price is $2/share and $3/share. Comment: If the share price is $2/share x 50 shares = $1,000 which is less than the $1,100 redemption value, the redemption value is used in the calculation.
If the share price is $3/share x 50 shares = $1,500 which is more than the $1,100 redemption value, $1,500 should be used in the calculation.
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Illustrated question (Convertibles): Conversion price of each bond = $50 When convertible bonds were issued, market value of each bond = $1,000, market value of each share = $30. Required: Calculate the conversion premium when convertibles were issued. Comment: Number of convertible shares = $1,000/$50 (conversion price) = 20 shares Conversion premium = Market value of convertibles – Market value of convertible shares = $1,000 – 20 shares x $30/share = $400 Conversion premium per share = $400/20 shares = $2/share |
Exam rehearsal question: Lane Co has in issue 3% convertible loan notes which are redeemable in five years' time at their nominal value of $100 per loan note. Alternatively, each loan note can be converted in five years' time into 25 Lane Co ordinary shares. The current share price of Lane Co is $3.60 per share and future share price growth is expected to be 5% per year. The before-tax cost of debt of these loan notes is 10% and corporation tax is 30%. What is the current market value of a Lane Co convertible loan note?
Comment: A. Conversion value = 3·60 x 1·055 x 25 = $114·87. Discounting at 10%, loan note value = (3 x 3·791) + (114·87 x 0·621) = $82·71 |
Exam rehearsal question: The 8% loan notes are convertible into eight ordinary shares per loan note in seven years’ time. If not converted, the loan notes can be redeemed on the same future date at their nominal value of $100. Par Co has a cost of debt of 9% per year. The ordinary shares of Par Co have a nominal value of $1 per share. The current ex dividend share price of the company is $10·90 per share and share prices are expected to grow by 6% per year for the foreseeable future. Required: What is the conversion value of the 8% loan notes of Par Co after seven years?
Comment: C |
Exam rehearsal question: The 8% loan notes are convertible into eight ordinary shares per loan note in seven years’ time. If not converted, the loan notes can be redeemed on the same future date at their nominal value of $100. Par Co has a cost of debt of 9% per year. The ordinary shares of Par Co have a nominal value of $1 per share. The current ex dividend share price of the company is $10·90 per share and share prices are expected to grow by 6% per year for the foreseeable future. Required: Assuming the conversion value after seven years is $126·15, what is the current market value of the 8% loan notes of Par Co?
Comment: B |
Exam rehearsal question: Discuss the attractions to a company of convertible debt compared to a bank loan of a similar maturity as a source of finance. (4 marks) Comment: Repayment: After the issue of convertible bonds, if company’s share price performs well and the share conversion value is greater than the floor value, investors are likely to convert debts into shares. This means company does not have to pay principal back to investors when this matures and it helps with cash flows. Debt capacity: The debt capacity would increase if the convertible bonds are paid off, ie being converted into shares as company’s gearing would reduce. This means company could take on extra debts to finance its activities. Lower interest rate: The interest rate is usually lower in convertible bonds than other traded debts without the conversion option and this helps company’s cash flows and profitability as lower interest expenses are incurred each period. Lower risks to investors: Investors may favour such convertible bonds as they offer a lower risk option to investors, ie if company’s share does not perform well, investors could convert them into cash value and obtain interests each period. |
Exam rehearsal question: Required: Discuss THREE advantages to Tufa Co of using convertible loan notes as a source of long term finance. (6 marks) Comment: Cost of finance: Tufa Co can pay lower interest expense to convertible loan note holders than traditional loan notes as the convertible loan note also contains the right to convert the notes into shares for holders. The interest payment of the convertible bond can save tax for Tufa Co and this further decreases the cost of finance. Risks: If convertible loan notes are redeemed as shares by holders, the debt capacity of Tufa Co can increase as the gearing of the business would decrease. Tufa Co may be able to obtain long term finance easier when issuing convertible loan notes as investors could receive fixed interest payment from the business and have the chance to become shareholders in the future. Cash flows: Tufa Co can save its cash by not repaying holders cash when holders decide to convert the convertible loan notes into shares when they are redeemed. Issuing convertible loan notes could help Tufa Co better plan its future cash flows as the company needs to settle the loan notes in the form of fixed interest payment. |
Exam rehearsal question: MFZ Co has 12 million ordinary shares in issue and has not issued any new shares in the period under review. The company is financed entirely by equity, and is considering investing $9.2 million of new finance in order to expand existing business operations. Required: Discuss the sources and characteristics of long-term debt finance which may be available to MFZ Co (8 marks) Comment: Long-term bank loan: The interest rate in the bank loan could either be at a fixed or a floating rate. The repayment of capital may be in the form of interest plus principal to be repaid regularly or interest to be repaid regularly with the full principal to be repaid when the loan matures. The loan would need to be secured against assets of MFZ Co, either non-current assets such as buildings or current assets. This reduces default risks from bank’s perspective. Bonds: Bonds could be issued to finance $9.2m funding needs. Bonds could either be redeemable or irredeemable, ie whether principal needs to be repaid to investors. Bonds can be publicly traded in the debt market and can also be issued in foreign currencies, known as Euro bonds. Convertible bonds: The coupon rate in the convertible bonds is likely to be lower than traditional bonds as they offer investors an option to become shareholders in the future. The market value of convertible bonds is likely to change as the change in company’s share price. If the converted shares value is higher than to redeem the bond into cash, investors are likely to convert bonds into shares when it matures. Deep discount bonds: This helps MFZ Co’s cash flows as lower interest costs are incurred each period. Zero coupon bonds: These are bonds issued by MFZ Co at a deep discount to their face value with no interest to be paid to investors regularly compared with the traditional bonds. Investors are likely to enjoy capital gains from the increase in bonds price in the secondary market. MFZ Co needs to repay the full principal to investors when bonds are mature and therefore, it helps MFZ Co’s cash flows as no interest costs are incurred each period. Tutorial note: There are 8 marks in this question specially asking for sources and characteristics. Therefore, 1 mark for each source with short explanation followed by another 1-2 marks for characteristics. Total 8 points would therefore earn you 8 marks. |
Exam rehearsal question: Identify and discuss briefly the factors that influence the market value of traded bonds. (5 marks) Comment: Coupon interest: If the coupon interest paid to investors increases, the market value of traded bonds increases as they are more attractive to investors. Frequency of coupon interest payment: If traded bonds coupon interests are paid more frequently, ie every month rather than every year, it is likely that its market value would increase. Redemption value: If traded bonds are redeemed more than its par value, their market value increases as they are more attractive to bonds investors. Required return: If the required return by bonds holders increases, this means they would like to pay less to buy those bonds, ie market value of traded bonds decreases. Convertibility: If there is a conversion option in traded bonds, the market value changes as it is affected by estimates about the company’s share prices. |
Long term equity finance
1. Internally generated funds:
- To retain profits in a business by not distributing them to ordinary shareholders, ie to reduce or to cut dividends.
- There are no additional issue costs of such funds.
- Shareholders who want dividends might call for a general meeting for such changes.
2. Initial public offer (IPO):
- This is where company’s shares can be publicly traded, commonly known as flotation. After IPO, companies could issue additional shares through public offerings (PO), rights issue or placing.
- Fees included in the IPO include professional fees (auditors and lawyers), stock exchange admission fees (depend on number of shares offered, listing markets such as main market or AIM. See ‘fee calculator’ on London Stock Exchange’s website), advertising fees and underwriting costs.
- References: Case study 1 – IPO process; Case study 2 – Different listing markets; Case study 3 – IPO failure and Case study 4 – Index.
Underwriting:
- This is to ensure shares could be successfully sold to the public. Underwriting fee is charged, usually 3%-7% of the capital raised.
- Issuing house - Shares are generally acquired by the issuing house (known as underwriters such as investment banks) before they are sold to the public.
- Syndicate - A group of investment banks may act as an underwriter.
Pricing shares:
- Fixed price offer:
- Sell shares to the general public at a fixed price where the price is set by the company and its advisors.
- If the price is too high – under subscriptions.
- Offer for sale by tender:
- Sell shares to the general public at the tendered price.
- A minimum price for shares is set, and investors bid for them.
- The issue price is then set based on the bids received, usually during the roadshow, bids are collected by advisors where the price band could be determined, ie issue price around $30 - $50 per share.
- All shares are sold to investors allowing them to receive a proportion of shares that they bid for at or above the lower price.
- References: Case study 5.
- Subsequent shares issue to raise capital:
- Rights issue – issue additional shares at a discounted price to the current market price
- Public offerings (POs) – issue additional shares at market price
- Private placement – issue additional shares directly to a few selected investors, and this may dilute shareholdings of existing shareholders
Case Study 1 - Process of listing in London Stock Exchange:
Case Study 2 – Listing markets:
Alternative Investment Market (AIM) |
Main Market Standard (For all debts and equity) |
Main Market Premium (For equity) |
|
Audited accounts |
Three years or such shorter period |
Three years or such shorter period |
Three years |
Minimum free float |
None |
25% |
25% |
Corporate governance |
None |
None |
Comply or explain |
Indices |
FTSE AIM Series |
None |
FTSE UK Series |
Case Study 3 – IPO failures:
Ridesharing company Lyft and ride-hailing company Uber’s performance have been poor, and their share prices have fallen below the IPO price since they were listed.
Case Study 4 - FTSE series:
- The FTSE 100 Index represents the performance of the 100 largest UK-domiciled blue-chip companies.
- The FTSE 250 Index is comprised of mid-sized companies measuring the performance of the mid-cap segments in the UK market which fall just below the FTSE 100 Index.
- The FTSE Small Cap consists of companies outside the FTSE 100 and FTSE 250 indices.
- The FTSE All-Share Index represents the performance of all eligible companies listed on the Main Market. It is considered to be the best performance measure of the overall London equity market, with the vast majority of money invested in funds benchmarked against it. The FTSE All-Share Index is the aggregation of the FTSE 100, FTSE 250 and FTSE Small Cap Indices.
- AIM indices include the FTSE AIM 50 UK Index; FTSE AIM 100 Index; FTSE AIM All-Share Index; and, FTSE AIM All-Share Supersector Index.
Case Study 5 - Offer for sale by tender:
A business wishes to issue 10 million shares and decides to use offer for sale by tender method. The business received the following bids from different investors:
Bids |
Number of shares (‘000) |
Bid price $ |
1 |
4,000 |
2.3 |
2 |
250 |
2.2 |
3 |
2,000 |
2.4 |
4 |
5,000 |
2.39 |
5 |
500 |
2.5 |
6 |
3,000 |
2.45 |
The first step is to rearrange the above bids on a descending order starting with the highest bid price.
Bids |
Number of shares (000) |
Bid price $ |
1 |
500 |
2.5 |
2 |
3,000 |
2.45 |
3 |
2,000 |
2.4 |
4 |
5,000 |
2.39 |
5 |
4,000 |
2.3 |
6 |
250 |
2.2 |
The next step is to determine the stop price, ie if the bid price is lower than the stop price, company could reject the offer. When accumulated shares exceed the number of shares to be expected to issue by the company, stop price could then be determined.
Bids |
Number of shares (000) |
Accumulated shares (000) |
Bid price $ |
1 |
500 |
500 |
2.5 |
2 |
3,000 |
3,500 |
2.45 |
3 |
2,000 |
5,500 |
2.4 |
4 |
5,000 |
10,500 > 10,000 |
2.39 – stop price |
5 |
4,000 |
2.3 |
|
6 |
250 |
2.2 |
In the above example, the stop price is $2.39/share.
The final step is to determine the number of shares to be allotted to shareholders, ie the number of shares to be issued in proportion to the total bid shares – 10,000/10,500 = 0.952
Bids |
Number of shares (000) |
Shares to be allotted (000) |
1 |
500 x 0.952 |
480 |
2 |
3,000 x 0.952 |
2,856 |
3 |
2,000 x 0.952 |
1,904 |
4 |
5,000 x 0.952 |
4,760 |
Total shares = |
10,000 |
The company would issue 10,000 shares to the above four investors at $2.39/share, 480 shares to the first investor, 2,856 shares to the second, 1,904 shares to the third and 4,760 to the final one. Total proceeds from the issue would therefore be $23,900 (10,000 shares x $2.39/share).
An example of IPO using offer for sale by tender is Line Corporation, an internet service and mobile application company. The issue price per share is 3,300 yen with more than 110 million Yen shares issued in its IPO.
3. Listing by introduction (Direct listing):
This is a choice for private companies to publicly trade their shares without going through the traditional IPO process, ie no need to engage with underwriters; no need to lock shares of original shareholders before they can be sold; shareholders can trade their shares on the first day when company obtains a listing status.
In the traditional IPO process, the share price is set by investors from roadshow which is then determined by the underwriter and company. However, under direct listing, the price is set by reference to the private valuation and many other factors such as sustained trading in the private market by the stock exchange. Again, human judgement places a vital role in setting the price.
Usually, not every company could use this approach to become listed as many of these companies do not have an easy to be understood business model and diverse shareholders base. However, workplace chat company Slack and the music streaming service Spotify successfully used this approach to obtain a listing status in the stock exchange.
Case Study – Direct listing requirement from New York Exchange
A company can qualify for a direct listing with at least 400 round lot (hundreds) holders and:
- a primary capital raise with public market value of at least $100M OR
- a $250M total public float or a combined aggregate of a primary capital raise and public float of at least $250M
A company with less than 400 round lot holders can be given a grace period to meet the minimum round lot requirement if it:
- has a public market value of at least $350M
- does a primary capital raise with a public market value of at least $250M
- has a combined aggregate of a primary capital raise and public float of at least $350M
Source: NESE
4. Private placement (placing):
- Another way to raise capital is to place shares directly to a few selected investors, ie wealthy individuals, insurance companies and pension funds.
- This is not a way to list company on the stock exchange and therefore, business prospectus is not usually required, and it does not need to be registered with listing authorities, ie U.S. Securities and Exchange Commission (SEC).
- This is a much quicker approach to raise capital than IPO with less information needed to be disclosed.
- This approach is usually used by businesses which lack of strong financial status nor do not have a good reputation for attracting general public to buy shares.
- Private placement approach could be used when businesses want to raise additional equity capital for the first time (initial private placement) or for public companies which want to further issue additional share capital.
5. Rights issue:
Basics of rights issue:
- A rights issue of share is to sell each share at a discounted price to the current market price to shareholders.
- 1 for 5 (or 1:5) rights issue at a discount of 20% (usually 17%-25%) to the current market price of $6/share at $4.8/share.
- If a shareholder currently holds 100 shares, he/she could subscribe 20 shares at $4.8/share.
- In most countries, existing shareholders should be offered the new discounted shares before new shareholders, and this is known as ‘pre-emptive rights’. This is to protect existing shareholders’ interest, ie not diluting their current shareholding. However, in the US, preemptive rights do not exist. In the UK, at least 14 days should be given to investors to decide whether they would accept the rights issue.
- A rights issue could be underwritten or non-underwritten, ie whether businesses engage an investment bank for the rights issue. Examples of underwriters include HSBC, Citigroup and Morgan Stanley.
- Businesses should decide whether rights could be transferred to another investor if the shareholder decides to forfeit the right to subscribe shares at a discount. Rights which could be transferred to other investors are commonly known as renounceable rights, otherwise these are non-renounceable rights. Traded renounceable rights are often presented as ‘Company name + R’, for example, ‘Sembcorp Marine R’. Reference – Case study later.
- This increases the number of shares to be issued and therefore, investor ratio such as earnings per share (EPS) would reduce.
Case Study – Pre-emption rights:
In 2020, due to the outbreak of Covid-19, pre-emption rights in the UK could be bypassed if the company issues less than 10% of its share capital to meet its capital needs.
Case Study – Renounceable rights:
Sembcorp Marine is a Singapore company where ‘Sembcorp Marine R’ stands for renounceable rights.
Source: www.shareinvestor.com
Case Study – Rights issue by IAG:
International Airlines Group (IAG) decides to use rights issue raising €2.75 billion funds in September 2020 supported by one of its largest shareholder Qatar Airways through the Covid-19 pandemic. However, Davy analyst viewed the rights issue would potentially dilute shareholders by at least 50% and therefore, has reduced the rating for IAG from ‘outperform’ to ‘neutral’ in August 2020.
Some terminologies:
- Cum-rights price - current market price, ie $10
- Issue (subscription) price - discounted share price, ie $8
- Ex-rights price – share price at which shares trade excluding rights
- Theoretical ex-rights price (TERP) - forecasted ex-rights price, ie (new share price x new shares + existing share price x existing shares) / (new + existing shares)
- Value of a right - TERP minus Issue price
- Rights value per original share - Cum-rights price minus TERP
Illustrated example: A business made a 1:4 rights issue at a discount of 20% to the current market price of $6.
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Exam rehearsal question: NG Co has exported products to Europe for several years and has an established market presence there. It now plans to increase its market share through investing in a storage, packing and distribution network. The investment will cost €13 million and is to be financed by equal amounts of equity and debt. The debt finance will be provided by a €6·5 million bond issue on a large European stock market. The equity finance will be raised in dollars by a rights issue in the home country of NG Co. Issue costs for the rights issue will be $312,000. The rights issue price will be at a 17% discount to the current share price. The current share price of NG Co is $4·00 per share and the market capitalisation of the company is $100 million. The currency of its home country is the dollar. The spot exchange rate is 1·3000 €/$. Required: Calculate the theoretical ex rights price per share after the rights issue. (4 marks) Comment: Amount of equity finance to be invested in euros = 13m/2 = €6·5 million Amount of equity to be invested in dollars = 6·5m/1·3000 = $5 million The amount of equity finance to be raised in dollars = 5m + 0·312m = $5·312m Rights issue price = 4·00 x 0·83 = $3·32 per share Number of new shares issued = 5·312m/3·32 = 1·6 million shares Current number of ordinary shares in issue = $100m/4·00 = 25 million shares Total number of shares after the rights issue = 25m + 1·6m = 26·6 million shares Theoretical ex rights price = ((25m x 4) + (1·6m x 3·32))/26·6 = 105·312/26·6 = $3·96 per share |
Exam rehearsal question: Drumlin Co has $5m of $0.50 nominal value ordinary shares in issue. It recently announced a 1 for 4 rights issue at $6 per share. Its share price on the announcement of the rights issue was $8 per share. What is the theoretical value of a right per existing share?
Comment: Value of a right = ((5m x $8 + 1·25m x $6)/6·25 m – $6)/4 shares = $0·4 per share |
Exam rehearsal question: The following financial information relates to MFZ Co, a listed company:
MFZ Co has 12 million ordinary shares in issue and has not issued any new shares in the period under review. The company is financed entirely by equity, and is considering investing $9.2 million of new finance in order to expand existing business operations. This new finance could be either long-term debt finance or new equity via a rights issue. The rights issue price would be at a 20% discount to the current share price. Issue costs of $200,000 would have to be met from the cash raised, whether the new finance was equity or debt. Required: Calculate the theoretical ex rights price per share for the proposed rights issue. (5 marks) Comment: Cash to be raised = investment needs + issue costs = $9.2m + $0.2m = $9.4 million Current share price = $56.4m/12m = $4.70 per share New shares to be issued = Additional cash/Rights issue price = $9.4m/$3.76 = 2.5m Theoretical ex rights price
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Exam rehearsal question: Bar Co is a stock exchange listed company that is concerned by its current level of debt finance. It plans to make a rights issue and to use the funds raised to pay off some of its debt. The rights issue will be at a 20% discount to its current ex-dividend share price of $7.50 per share and Bar Co plans to raise $90 million. Bar Co believes that paying off some of its debt will not affect its price/earnings ratio, which is expected to remain constant.
The 8% bonds are currently trading at $112·50 per $100 bond and bondholders have agreed that they will allow Bar Co to buy back the bonds at this market value. Bar Co pays tax at a rate of 30% per year. Required:
Comment: A. Theoretical ex rights price Rights issue price = 7·50 x 0.8 = $6 per share B. Financial acceptability to shareholders of buying back bonds Calculation: The $90m proceeds from the rights issue to buy back bonds which are currently trading at $112.5/bond, Bar Co could buy back 0.8 million bonds ($90m/$112.5/bond). Total reduction in book value of liability in the statement of financial position would therefore be 0.8m bonds x $100/bond = $80m. Interest saved by reducing bonds = $80m (nominal value) x 8% (coupon rate) = $6.4m annually.
Discussion: The revised share price is $7.08/share less than the $7.2/share TERP and this means shareholders wealth will decrease as a result of the bonds buyback. From the financial perspective, this proposal should not be accepted. However, the share price after rights issue is calculated based on the unchanged P/E ratio as before the rights issue. This assumption may not be correct as the redemption of bonds reduces liability and therefore, reduces its financial risks. Cost of equity is likely to reduce as a result of this and therefore, share price is likely to increase and shareholders could benefits from the capital gain. Tutorial note: the accounting entry for buyback (not required in the exam)- Dr Non-current liability $80m Dr Loss $10m Cr Bank $90m |
Exam rehearsal question: Tinep Co is planning to raise funds for an expansion of existing business activities. Required: Comment: Pre-emptive rights: In most countries, pre-emptive rights are in place to protect existing shareholders’ interest and therefore, it may take longer to finish the rights issue. However, in some countries these are not considered and therefore, reduces time required. Issue price: Relative cost: Ownership: Financial risk: Tutorial note: 1.5 marks – 2 marks per discussion in this question. Make sure your discussion is straight to the point with examples. |
Shareholders’ options regarding rights issue:
- Take up the rights - pay cash (issue price x additional shares) + shares value (with additional shares at TERP)
- Sell the rights - get cash (value of a right x additional shares) + shares value (with existing shares x TERP)
- Do nothing - existing shares x TEPR
- Conclusion:
Situations/Actions |
Actual ex-rights price = TERP |
Actual ex-rights price < TERP |
Actual ex-rights price > TERP |
Best decisions |
Take up rights issue or sell rights |
Sell shares |
Take up rights issue or sell rights |
Worst decision |
Do nothing |
Take up rights issue or sell rights (still better than do nothing) |
Do nothing (better than sell shares) |
Illustrated example:
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Case Study – Share price drops after the rights issue:
Huaren Pharmaceutical is a public listed company in mainland China specialsed in R&D, production and sales of non PVC large volume preparation in soft bags. It decided to raise additional funds through a rights issue of shares (2 for 10) in February 2018 at a price of RMB 3.56 per share. After the rights issue, the share price dropped by 77% compared with the share price before the rights issue. Reasons for this include the company has been overvalued recently, and some key shareholders have pledged their shares which make the company seem riskier.
Exam rehearsal question: The following financial position statement as at 30 November 2010 refers to Nugfer Co, a stock exchange-listed company, which wishes to raise $200m in cash in order to acquire a competitor.
The recent performance of Nugfer Co in profitability terms is as follows:
Notes:
Required: Evaluate suitable methods of raising the $200 million required by Nugfer Co, supporting your evaluation with both analysis and critical discussion. (15 marks) Comment: Short term borrowings: Short term borrowings as a way to finance the acquisition would further increases its financial risk given the existing debt to equity ratio including short term borrowings is 118% (((100 + 160)/221) = 118%). Besides, the interest costs of short-term borrowings (8%) are higher than the costs of long term debt (6%) and this would worsen its cash position as Nugfer Co did not have any cash deposits. Long term borrowings: The current debt to equity ratio which is based on long term debt is 45% ((100/221) = 45%) and if there is an increase in long term borrowings, the increase in financial risks would be lower than if Nugfer Co uses the short term borrowings option. However, the interest cover ratio has decreased over the years from 7 times ($41.7m/$6m) in 2007 to 3 times in 2010 given the finance costs has tripled over the years. If there is an increase in long term borrowings, this should further reduce the interest cover ratio and hence increase financial risks. Profit margins such as operating or net profit margin have decreased over the years, ie for net profit margin, from 34% ($25m/$122.6m) to 30% ($26.5m/$189.3m) and if there is a further increase in finance costs, it would further impair company’s profitability and cash position which affects their future expansion plan such as issue of shares. Convertible debts: The use of convertible debts would also increase financial risks of Nugfer Co as the liability increases up until when they are redeemed. However, convertible debts carry a lower interest cost than traditional bonds and this would help company’s cash flows. Nugfer Co may also get a premium when the convertible debt is issued for the first time, however, there is a lack of other information about this company and it seems the profitability of Nugfer Co has worsened, it is questionable of whether Nugfer Co could still obtain a premium when this is issued. Public issue: Nugfer Co did not pay any dividends in the last four years, it may be difficult to issue additional shares through public offering to additional shareholders. Besides, additional share issue would further reduce the share price and this needs to be approved by shareholders which takes time. Sale and leaseback of non-current assets: Nugfer Co could sell its own non-current assets to financial companies and lease them back and pays rental expenses. However, the amount of cash Nugfer Co could get depends on the quality of those assets. Conclusion: Overall, the financial performance and position of Nugfer Co seem to be poor and it is best to fund the $200m partly using long term borrowings and partly using sale and leaseback transaction. Tutorial note: each point would be worth 1.5-2 marks in the exam. Dive deeper, conquer those exams, and truly make your mark by grabbing your spot in our ACCA online course today at www.globalapc.com – let’s crush this together! |
Categories: : Financial Management (FM)