- 14 Marks
Question
GoodLife Innovations is planning to expand its operations, which will boost its profit before interest and tax by 20%. The company is evaluating whether to fund the GH¢4,000,000 needed for this expansion through equity or debt financing.
If equity financing is chosen, the company will offer a 1-for-5 rights issue to existing shareholders at a 20% discount to the current ex-dividend share price of GH¢5 per share. The par value of the ordinary shares is GH¢1 per share. Alternatively, if debt financing is selected, GoodLife Innovations will issue 20,000 8% loan notes, each with a par value of GH¢200.
The following information was extracted from the financial statement prior to raising new finance:
| GH¢’000 | Amount |
|---|---|
| Profit before interest and tax | 3,194 |
| Finance costs (interest) | (630) |
| Taxation | (564) |
| Profit after tax | 2,000 |
| Equity & Liability: | |
| Ordinary shares | 5,000 |
| Retained earnings | 10,976 |
| Long-term liabilities: 7% loan notes | 9,000 |
| Total equity & liabilities | 24,976 |
GoodLife Innovations currently has a price/earnings ratio of 12.5 times. Corporate tax is payable at a rate of 22%.
Required:
i) Calculate the theoretical ex-rights price per share.
ii) Calculate the revised earnings per share after the business expansion:
- assuming equity finance is adopted.
- assuming debt finance is adopted.
iii) Determine the revised share prices under both financing methods after the business expansion.
iv) Determine which financing method should be used for the planned business expansion using computations for interest cover and share price changes.
Answer
i) Theoretical Ex-Rights Price per Share
| Calculation | Amount (GH¢) |
|---|---|
| Current share price | 5.00 |
| Right issue discount (20%) | 4.00 |
| TERP Calculation: | [(5 × 5) + (1 × 4)] / 6 |
| TERP | 4.83 |
ii) Revised Earnings Per Share (EPS) Calculations
Assuming Equity Finance
| Calculation | Amount (GH¢’000) |
|---|---|
| Increased PBIT (20%) | 3,832 |
| Finance costs | (630) |
| Revised profit before tax | 3,202 |
| Taxation @ 22% | (704) |
| Revised profit after tax | 2,498 |
| Increased number of shares | 6,000,000 |
| Revised EPS | 0.42 |
Assuming Debt Finance
| Calculation | Amount (GH¢’000) |
|---|---|
| Increased PBIT (20%) | 3,832 |
| Finance costs (630 + 320) | (950) |
| Revised profit before tax | 2,882 |
| Taxation @ 22% | (634) |
| Revised profit after tax | 2,248 |
| Number of shares | 5,000,000 |
| Revised EPS | 0.45 |
iii) Revised Share Prices
| Calculation | Amount (GH¢) |
|---|---|
| Equity Finance (P/E × EPS) | 12.5 × 0.42 = 5.25 |
| Debt Finance (P/E × EPS) | 12.5 × 0.45 = 5.63 |
iv) Financing Method to be Used
Interest Cover Computations
| Calculation | Amount |
|---|---|
| Current interest cover | 3,194 / 630 = 5.1 times |
| Equity finance interest cover | 3,832 / 630 = 6.1 times |
| Debt finance interest cover | 3,832 / 950 = 4.0 times |
Share Price Changes
| Calculation | Amount (GH¢) |
|---|---|
| Equity Finance | Capital gain of 0.42 (5.25 – 4.83) |
| Debt Finance | Capital gain of 0.63 (5.63 – 5.00) |
- Tags: Debt Financing, Earnings Per Share, Financial Decision-Making, Rights Issue, Share Price
- Level: Level 2
- Topic: Sources of finance: debt, Sources of finance: equity
- Series: Nov 2024
- Uploader: Salamat Hamid