ACCA FM Past papers - Question 4ab - June 2015

June 2015

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Question 4ab

Grenarp Co is planning to raise $11,200,000 through a rights issue. The new shares will be offered at a 20% discount to the current share price of Grenarp Co, which is $3·50 per share. The rights issue will be on a 1 for 5 basis and issue costs of $280,000 will be paid out of the cash raised. The capital structure of Grenarp Co is as follows:

	$m	$m
Equity
Ordinary shares ($0·50 nominal)	10
Reserves	75
		85
Non-current liabilities
8% Loan notes		30
		115

The net cash raised by the rights issue will be used to redeem part of the loan note issue. Each loan note has a nominal value of $100 and an ex interest market value of $104. A clause in the bond issue contract allows Grenarp Co to redeem the loan notes at a 5% premium to market price at any time prior to their redemption date.

The price/earnings ratio of Grenarp Co is not expected to be affected by the redemption of the loan notes.

The earnings per share of Grenarp Co is currently $0·42 per share and total earnings are $8,400,000 per year. The company pays corporation tax of 30% per year.

Required:
(a) Evaluate the effect on the wealth of the shareholders of Grenarp Co of using the net rights issue funds to redeem the loan notes. (8 marks)

(b) Discuss whether Grenarp Co might achieve its optimal capital structure following the rights issue. (7 marks)

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