- 20 Marks
Question
You should assume that the current date is 31 December 2019.
You work for Eko Corporate Finance (ECF). One of the clients for whom you are responsible is Gap Plc (GP).
Gap Plc is a listed company and is seeking to raise ₦560 million to invest in new projects during 2020. Currently, Gap Plc is financed by equity. However, at a recent board meeting, the finance director stated that, since other companies in Gap Plc’s industry have average gearing ratios (measured by debt/equity by market value) of 30% (with a maximum of 40%) and an average interest cover of 6 times (with a minimum of 5 times), perhaps the company should access the debt markets. The finance director presented to the board two alternative sources of finance to raise the ₦560 million.
Equity Issue:
The ₦560 million would be raised by a 1 for 2 rights issue, priced at a discount on the current market value of GP’s shares.
Debt Issue:
The ₦560 million would be raised by an issue of 7% coupon bonds, redeemable on 31 December 2029. The yield to maturity (YTM) of the bonds would be equal to the YTM of the bonds of Eko Ventures (EV), another listed company in Gap Plc’s market sector. Eko Ventures has a similar risk profile to Gap Plc and has recently issued its bonds. Eko Ventures’ bonds have a coupon of 7%, will be redeemed in four years at par, and their current market price is ₦110 per ₦100 nominal value.
There were concerns expressed by a number of board members regarding the debt issue since it has been the long-standing policy of the company not to borrow. Their concerns were how Gap Plc’s shareholders and the stock market would react. The company’s cost of capital would increase as a result of the borrowing, leading to a fall in the company’s value.
An extract from Gap Plc’s most recent management accounts is shown below:
| ₦m | |
|---|---|
| Operating profit | 200 |
| Taxation at 20% | (40) |
| Profit after tax | 160 |
Additional Information:
- Gap Plc has an equity beta of 1.1
- The risk-free rate is expected to be 3% p.a.
- The market return is expected to be 8% p.a.
- Gap Plc’s current share price is ₦5 per share ex-dividend.
- Gap Plc has 320 million ordinary shares in issue.
Required:
a. Calculate, using the CAPM, Gap Plc’s cost of capital on 31 December 2019. (1 Mark)
b. Assuming a 1 for 2 rights issue is made on 1 January 2020:
i. Calculate the discount the rights issue represents on Gap Plc’s current share price. (1 Mark)
ii. Calculate the theoretical ex-rights price per share. (1 Mark)
iii. Discuss whether the actual share price is likely to be equal to the theoretical ex-rights price. (4 Marks)
c. Alternatively, assuming debt is issued on 1 January 2020:
i. Calculate the issue price and total nominal value of the bonds that will have to be issued to give a YTM equal to that of Eko Ventures’ bonds in the above calculation. (5 Marks)
ii. Discuss the validity of the use of the YTM of Eko Ventures’ bonds in the above calculations. (3 Marks)
d. Outline the advantages and disadvantages of the two alternative sources for raising the ₦560 million, discuss the concerns of the board regarding the bond issue (using the gearing and interest cover information provided by the finance director), and advise Gap Plc’s board on which source of finance should be used. (5 Marks)
Answer
a) Gaps Plc‟s cost of capital on December 2019 = 3 + (1.1 × (8 – 3)) = 8.5%
b) i) A 1 for 2 rights issue will require 320/2 = 160 million new shares to be issued.
The price per share = ₦560 million/160 million = ₦3.50
A discount on the current market price of (₦5 – 3.50)/5 = 30% (or ₦1.50).
ii) The theoretical ex-right price is:
Theoretical ex-rights price = ₦13.50/3 = ₦4.50
iii) The actual share price will depend on the market‟s reaction to the rights issue e.g. whether it is fully taken up, and whether the proceeds are invested in positive net present value projects. If we were told the net present value of the projects, this could be incorporated in the theoretical ex-rights price of ₦4.50, giving a more realistic estimate of the actual share price post rights issue.
c) (i) The yield to maturity of the Eko Ventures bonds is calculated as follows:
IRR = 3 + (4.82/(4.82 + 19.51) × 7 = 4.39% say 4%
The issue price is:
The total nominal value will be = 560/(124.38/100) = ₦450.23 million
ii) EV has similar risk to GP so it may be reasonable to assume that bond holders would require the same yield to maturity (YTM) in return for investing with either company. But how similar is similar? Eg, how comparable is EV to GP in terms of gearing? However, the EV bonds have only four years until redemption, whilst the GP bonds mature in ten years. It is likely that bond holders would require a higher yield to redemption for investing in the GP bonds to compensate them for the risk of investing for a further six years.
d) The Gearing and Interest Cover Ratios of GP Immediately After the Bond Issue
Interest Cover:
- Interest: ₦450.23 × 7% = ₦31.52m
- Interest Cover: (₦200 / ₦31.52) million = 6.35 times
Gearing by Market Values Assuming the Current Market Price Per Share:
- Market Capitalisation: 320 × 5 = ₦1,600 million
- Gearing (D/E): 560 / 1,600 = 35%
In Time:
Both interest cover (more operating profits) and gearing (greater equity value) are likely to improve with:
- Acceptance of positive NPV projects
- Any favourable market reaction to the issuance of debt and its tax shield
An Outline of General Advantages and Disadvantages of Debt vs Equity
- Control: If all the rights are not taken up by the existing shareholders, there will be dilution of control. Debt issuance has a neutral effect on control.
- Cost: Debt should have a lower cost of capital due to:
- Lower risk (both income and capital repayment)
- The fact that interest on debt is allowed for corporate tax
- Security: Providers of debt finance will usually require some form of tangible security for any debt capital.
- Cash Flows: While debt finance is cheaper than equity, it places mandatory payment obligations on the company for interest. Payment of dividends depends on the availability of cash flow.
- Issue Cost: Generally, it is cheaper to issue equity (especially rights issue) than bonds.
EPS (Earnings Per Share) Calculations
- Current EPS: ₦160m / 320 = 50k
- EPS with Rights Issue: ₦160m / 480 = 33k
- EPS with a Bond Issue:
- Adjusted earnings after tax: ((₦200m – 31.52) × 0.80) = ₦134.78m
- EPS: ₦134.78m / 320 = 42k
Addressing the Concerns of the Board
The company will have:
- A gearing ratio of 35%, which is between the industry maximum (40%) and average (30%).
- An interest cover of 6.35 times, which is slightly above the industry average of 6.
- Since this is the first time GP has borrowed, both shareholders and the stock market might be concerned. They might prefer these ratios to be around or better than the industry averages.
- Borrowing should reduce the current 8.5% cost of capital, since:
- Debt is generally less expensive than equity as it is less risky for debt holders.
- The company receives tax relief on interest paid.
- Increased financial risk may cause shareholders to require a higher return, but this is unlikely to offset the cheaper proportion of debt finance.
- Company Value: The value should increase due to:
- Reduction in the cost of capital
- New funds being invested in positive NPV projects
Advice
It would be prudent for the company to:
- Restrict its borrowing to the industry average gearing level, especially since its interest cover is slightly above the industry average.
- Avoid borrowing the full ₦560 million.
- Revise its plans for raising the finance, such as:
- Issuing both debt and equity to ensure gearing and interest cover ratios are more favourable.
- Selling surplus assets.
- Tags: CAPM, Debt Financing, Gearing Ratio, Interest Cover, Rights Issue
- Level: Level 3
- Uploader: Kofi