4(a) - This question asked candidates to evaluate the effect on the wealth of shareholders of using rights issue funds to redeem loan notes. Many answers failed to gather many marks and a small number of candidates did not offer any answer at all.

Changes in share price are a way of assessing changes in shareholder wealth and so the share price after redeeming loan notes could be compared with the share price following the rights issue (the theoretical ex rights price or TERP).

The share price after redeeming the loan notes could be found by multiplying the post redemption earnings per share (EPS) by the unchanged price/earnings ratio of the
company.

A good way to start answering the question was to consider the planned rights issue, and many answers were able to calculate correctly the rights issue price, the number of new shares offered in the rights issue, the net cash raised after issue costs, and the TERP (whether or not considering issue costs).

Some answers stopped at this point, ignored the proposed redemption of loan notes, and mistakenly discussed how the wealth of shareholders had fallen because the TERP was lower the current market price.

Even though the question gave the amount of cash the company planned to raise, some answers calculated their own figure for the cash raised and incorrectly based their answer on that.

For example, some answers adopted a 5 for 1 basis for the rights issue, rather than the 1 for 5 basis given in the question, while others added the issue costs to the cash raised figure provided.

The most direct way of assessing the effect of redeeming loan notes was calculating the after-tax interest cost saving, adding this to the current earnings, and calculating a revised EPS.

The interest cost saving is based on the nominal value of loan notes redeemed. Some answers incorrectly based the interest cost saving on the market value of loan notes redeemed.

Some answers incorrectly based an assessment of changes in shareholder wealth on changes in the capital structure of the company, which was provided in the question.

4(b) - Since it was planned to replace debt with equity, gearing would fall. A number of answers considered whether this fall in gearing would result in an optimal capital structure from a theoretical point of view, touching on the traditional view and the views of Miller and Modigliani, gaining credit for this approach.

Another approach adopted by some candidates was to consider the relative costs of equity and debt, arguing from a real-world standpoint that WACC was likely to rise if cheaper debt were replaced by more expensive equity.

Candidates were asked to discuss whether the company might achieve its optimal capital structure following the rights issue. Even though optimal capital structure theory has been examined regularly, many answers were unsatisfactory.

There are several ways of answering this open-ended question. Many answers started with a definition of an optimal capital structure, which is the point where the weighted average cost of capital (WACC) is minimised and the market value of a company is maximised.

Some answers incorrectly stated that an optimal capital structure was a 50/50 mix of equity and debt.