Page 32 - CIMA May 18 - MCS Day 1 Suggested Solution

CIMA MAY 2018 – MANAGEMENT CASE STUDY

Alternatively Menta could consider a rights issue to its’ existing shareholders. A rights issue would
have the advantage of maintaining the current ownership and would avoid any dilution of
ownership. It would also be cheaper compared to a full market issue. A rights issue may have a
greater chance of success as it involves existing shareholders rather than trying to persuade new
investors to provide the required finance. However, as a rights issue is typically priced at a
discount to the market price it may not raise as much finance in comparison to an issue of shares
at market value.

Menta could consider creating and issuing alternative classes of shares such as preference shares.
However, they would need to be careful as to whether the preference shares would meet the
definition of a financial liability (debt) or not. If the preference shares were redeemable or carried
an obligation to pay a dividend, they would have to be classed as debt finance. The related
dividends would be recognised as finance costs and charged against profit as an expense. This in
turn would have the impact of increasing the gearing ratio and reducing interest cover.

Creating an additional class of shares would be beneficial to Menta if it wanted to be able to be
pay different levels of dividend to new shareholders compared to current equity shareholders.

Compound instruments
A further option would be to issue a compound financial instrument, such as a convertible bond.
This would enable Menta to raise finance at a lower cost compared to simple debt finance. Since
convertible bonds will be recorded partly as debt and partly as equity they would also have a less
adverse effect on the gearing ratio compared to regular bonds.

Investors may consider convertible bonds to be a less risky way of investing in Menta and may be
attracted by the potential of becoming an equity shareholder in the future with the ability to
receive future dividends.
Calculation of WACC

Cost of debt
Effective interest rate (per exercise 1) is 8.0% in 2017 and 5.4% in 2016.

Effective tax rate is 22% (to nearest %) in 2017 and 24% 2016.

Based upon 2017, the post‐tax cost of debt is therefore in the region of 8.0% x (1‐0.22) = 6.2%,
and slightly higher in 2016 at 8.4% x (1‐0.24) = 6.4% for 2016 assuming that debt is long‐dated or
irredeemable. Even though there was a part‐repayment of the debt finance in 2017, it had been
classified as a non‐current liability, indicating that it was an early or voluntary repayment by
Menta.

Cost of equity
It is not possible to calculate the cost of equity as the share price of Menta is not provided.

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