Question 4c
Bar Co is a stock exchange listed company that is concerned by its current level of debt finance. It plans to make a rights issue and to use the funds raised to pay off some of its debt. The rights issue will be at a 20% discount to its current ex-dividend share price of $7·50 per share and Bar Co plans to raise $90 million.
Bar Co believes that paying off some of its debt will not affect its price/earnings ratio, which is expected to remain constant.
| income statement information | |
| $m | |
| turnover | 472 |
| cost of sales | 423 |
| ----- | |
| profit before interest and tax | 49 |
| interest | 10 |
| ----- | |
| profit before tax | 39 |
| tax | 12 |
| ----- | |
| profit after tax | 27 |
| ----- | |
| statement of financial position information | |
| $m | |
| equity | |
| ordinary shares ($1 nominal) | 60 |
| reserves | 80 |
| ----- | |
| 140 | |
| long-term liabilities | |
| 8% bonds ($100 nominal) | 125 |
| ----- | |
| 265 | |
| ----- |
The 8% bonds are currently trading at $112·50 per $100 bond and bondholders have agreed that they will allow Bar Co to buy back the bonds at this market value. Bar Co pays tax at a rate of 30% per year.
Required:
Calculate and discuss the effect of using the cash raised by the rights issue to buy back bonds on the financial risk of Bar Co, as measured by its interest coverage ratio and its book value debt to equity ratio.