Devonian plc has the following long-term capital structure as at 30 November Year 4:

The business has no long-term loans.

In the year to 30 November Year 4, the operating profit (profit before interest and taxation) was £40 million and it is expected that this will increase by 25 per cent during the forthcoming year. The business is listed on the London Stock Exchange and the share price as at 30 November Year 4 was £2.10.

The business wishes to raise £72 million in order to re-equip one of its factories and is considering two possible financing options. The first option is to make a one-for-five rights issue at a discount price of £1.80 per share. The second option is to take out a long-term loan at an interest rate of 10 per cent a year. If the first option is taken, it is expected that the price/earnings (P/E) ratio will remain the same for the forthcoming year. If the second option is taken, it is estimated that the P/E ratio will fall by 10 per cent by the end of the forthcoming year.

Assume a tax rate of 30 per cent.

Required:

(a) Assuming a rights issue of shares is made, calculate:

(i) The theoretical ex-rights price of an ordinary share in Devonian plc 

(ii) The value of the rights for each original ordinary share.

(b) Calculate the price of an ordinary share in Devonian plc in one year’s time assuming:

(i) A rights issue is made 

(ii) A loan issue is made.

Comment on your findings.

(c) Explain why rights issues are usually made at a discount.

(d) From the business’s viewpoint, how critical is the pricing of a rights issue likely to be?

Transcribed Image Text:

Ordinary shares 25p fully paid General reserve Retained earnings £m 50.0 22.5 25.5 98.0