Question 4a, b
Examiners Report

Question 4(a) 
The requirement here was to calculate the theoretical ex rights price per share and most answers did this correctly.

Question 4(b) 
This part of question 4 required candidates to calculate and discuss whether using the rights issue cash to buy back bonds was acceptable to shareholders, commenting on the belief that the price/earnings ratio would remain constant.

Good answers calculated the current price/earnings ratio: the nominal value of the bonds redeemed ($80 million); the nominal value of the bonds remaining in the statement of financial position ($45 million); the reduction in the interest payable each year (down from $10 million to $3.6 million); the revised earnings and earnings per share values; and the revised share price (by multiplying the revised earnings per share by the current price/earnings ratio). The revised share price could then be compared with the theoretical ex rights price per share to assess the effect on shareholder wealth (a capital loss).

Answers lost marks to the extent that they did not achieve the elements described above. Answers that did not calculate the effect of redeeming $80 million of bonds could discuss in general terms only whether buying back bonds would be acceptable to shareholders. Many answers used the assumption of a constant price/earnings ratio, together with the theoretical ex rights price per share, to calculate implied earnings per share figure, but this serves no purpose and does not take account of buying back bonds.

Although the question said that the company planned to use the rights issue funds to pay off some of its debt, some answers assumed incorrectly that all of the bonds were to be bought (using reserves to finance the difference, even though these are not cash).

Some answers calculated a revised price/earnings ratio using the theoretical ex rights price per share, but the statement that the price/earnings ratio was expected to remain constant meant that a revised share price could be calculated from the revised earnings per share. The theoretical ex rights price per share is the share price before the rights issue funds are used: once these funds are used, the share price will change, so the theoretical ex rights price per share cannot be used to calculate a revised price/earnings ratio.

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