Question $1$

$(40$ Marks$)$

$($Capital structure decision making, learning units $7,13$ and $14)$

Read the following case and then answer the required section below the case:

Offices Ltd$.$ is a construction company focused on office space, which in the past had a large market capitalisation and turnover, but, after the recent pandemic, finds itself struggling to recover to its past stature in the construction industry due to the lower demand for office space. The company has, over the past few years sold off all its subdivisions and is now focussed solely on its core competency of building offices.

Demand for new offices has remained subdued since $2020,$ however, there is still enough demand for the company to stay afloat. The management of Offices Ltd $($from hereon, management$)$ believes that the company can operate in this environment and return healthy profits due to its experienced staff. Management believes in the turnaround plan and the prospects of the company and is sure that it will return to being a large competitor in its industry, however, it is not expected that the company will return to its size pre the pandemic. Due to low demand, the company is cash poor and management wishes to raise more funds to implement the proposed turn$-$around plan, which is based around reducing debt repayments $($lowering financial leverage$)$ and focusing on their core competency.

Below follows some financial information regarding the company:

Current number of shares in issue: $200000000$

Current share price: $30$ c

Current capital structure: Assets $=$ R$200000000$; Liabilities$=$ R$100000000$; Equity $=$ R$100000000$

Current EBIT $($operating profit$)=$ R$20000000$

Current interest expense $=$ R$12000000$

Tax rate: $27\%$

Current beta: $1\mathrm{.}9$

Risk free rate: $8\%$

Market risk premium: $5\%$

The company has had to incur a lot of debt to stay afloat and is planning a rights issue to raise funds to repay some of its debts and to implement its turn$-$around plan. Management estimates that it needs R$20000000$ over and above any retained earnings to implement the turnaround plan while they wish to lower its debt by R$50000000$ to bring about better profitability due to reduced interest payments, together with more future flexibility. It is not expected that EBIT would change for the foreseeable future and that any effect of the turn$-$around plan would only be felt later. The company will, immediately, use R$50000000$ to retire debt to that amount, while the R$20000000$ for the turn$-$around plan would be kept as cash initially. The interest payment is expected to fall in line $($proportionally$)$ with the reduction in the amount of debt.

Required:

a$.)$ If a company changes its capital structure, what do you expect would happen to its risk profile and the return it is expected to generate.

$(8$ Marks$)$

$2$

b$.)$ Considering the above case, what capital structure theory, or combination of theories, as described in chapter $14($trade$-$off theory; pecking order theory; market timing; financial flexibility$)$ is evident in the case? Argue your case at the hand of the description in your textbook, but do so in your own words.

$(4$ Marks$)$

c$.)$ In terms of the behavioural finance perspective, argue whether there is over or under optimism from management in the case and briefly discuss how this may affect the capital structure decision.

$(3$ Marks$)$

d$.)$ Determine the amount of funding that the company requires and the number of rights the company would have to issue if it is assumed that transaction and related costs amount to $10\%$ of the value of each right issued, while it is expected that the issue will be fully taken up and the price of a right is set to $25$ c $.$

$(4$ Marks$)$

e$.)$ Calculate the theoretical price per share after the issue and the WACC for the company after the rights issue.

$*$HINT: equity would be the theoretical price per share multiplied by the new amount of shares outstanding

$(10$ Marks$)$

f$.)$ Calculate the current ROE and the expected ROE after the rights issue and compare the two in your own words $($write no more than two sentences$).$

$(4$ Marks$)$

g$.)$ Briefly argue for or against the rights issue and restructuring plan. Provide at least one real$-$world example of a company that used a rights issue to raise funds and discuss the subsequent performance of the company, to staff your argument. $(7$ Marks$)$