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Development of financial strategy

Solution

(a) Pre-project ratios:

Interest cover = $15m/$4m = 3.75 times

Earnings per share (EPS) = $7.7m/16m = 48.1 cents per share

Earnings yield = EPS/Share price = $0.481/$2.70 = 0.178, or 17.8%

P&L forecasts Debt used Rights issue
$m $m
PBIT ($15m + $4m) 19.0 19.0
Interest (W1) (5.2) (4.0)
–––– ––––
PBT 13.8 15.0
Tax at 30% (4.1) (4.5)
–––– ––––
9.7 10.5
–––– ––––
(W1) Interest on the new debt is 6% of $20m i.e. $1.2m. Assume that
interest on the existing borrowings stays constant.

Share price workings:

Rights issue

If the rights issue goes ahead, the value of the shares after the rights
issue will be the theoretical ex-rights price (TERP) of $2.63 (given).

N.B. The calculation of this TERP will be covered in detail in the later
chapter: 'Financing – Equity finance'.

However, since the rights issue will be used to fund the new project with
an NPV of $8m, the value of the project will also be reflected in the new
share price, increasing the share price to $2.63 + [$8m/(16m shares +
8m new shares)] = $2.96.
Debt finance

If debt finance is used to fund the new project, the share price should rise
after the project has been taken on, to reflect the NPV of the new project.

Expected share price = $2.70 + ($8m/16m shares) = $3.20.

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