CORPORATE FINANCE (UKFF3013)

MAY 2022 TRIMESTER

TUTORIAL 5 (WEEK STARTING 21 FEB 2022)
EQUITY FINANCE (CHAPTER 4)

QUESTION 1
Discuss the reasons why a rights issue could be an attractive source of
finance for public listed companies

ANSWER
Financing the investment by an issue of ordinary shares through right issue
could offer several advantages. Gearing level would fall because of larger
proportion of equity capital versus smaller proportion of debt capital
Interest cover would increase because of lower interest amount and higher
profit before tax. The financial risk faced by the company would thus be
reduced, making it a more attractive investment prospect on the stock market.
This could have a positive effect on the company’s share price. Ordinary
shares do not carry a commitment to make regular payments such as interest
on debt, giving a company a degree of flexibility in rewarding shareholders in
financial terms. This must be balanced against the common desire of
shareholders for a regular and increasing dividend. Ordinary shares are
permanent capital since they do not need to be repaid. A company would thus
avoid the need to find funds for redemption (bonds) that would arise if it
issued debentures. Because the fixed assets of the company would increase
but its burden of long-term debt would be unchanged, a company would find it
easier to raise additional debt in the future. This could be useful when the
need arises to redeem the existing debentures. A rights issue would not
necessarily disturb the existing balance of ownership and control between
shareholders. Equity finance will decrease gearing and financial risk.
A rights issue will not dilute existing patterns of ownership and control.

QUESTION 2
FAM Berhad is considering making a 1 for 5 rights issue at a 20 percent
discount to the current share price of RM5.50 per share. The funds would be
used to finance expansion of current business operations. FAM Berhad has in
issue 2.3 million ordinary shares and profit after tax in the last year was
RM1.38 million. FAM Berhad expects an after-tax return of 15 percent on the
new funds raised. A non-executive director has advised FAM Berhad that
using the rights issue to fund expansion of business activities will result in a
fall in earnings per share, which will not be welcomed by the ordinary
shareholders of the company.
(a) Calculate:
1. Rights issue price

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 CORPORATE FINANCE (UKFF3013)
MAY 2022 TRIMESTER
TUTORIAL 5 (WEEK STARTING 21 FEB 2022)
EQUITY FINANCE (CHAPTER 4)

2. The theoretical ex-rights price per share

3. The value of the rights
4. Number of new shares that will be issued
5. Finance raised by the rights issue
6. After-tax returns on new funds
7. Revised earnings
8. Revised number of shares
9. Revised earnings per share
10. Current earnings per share
11. Current price/earnings ratio
12. New share price (assuming no change in PER)
(b) Explain why the return required by ordinary shareholders is different from the
return required by bondholders.

ANSWER

(1) Rights issue price $5.50 x 0.8 RM4.40

(2) Theoretical ex right price ((5 x $5.50) + (1 x RM5.32 per

(benchmark) $4.40)/ 6 share

(3) Value of rights 5.32(TERP) – 92sen or

4.40(Rights issue 18.3sen per
pr) existing share

(4) New shares issued 2.3m x 0.2 (1/5) 460,000 shares

(5) Finance raised 460,000 x $4.40 RM2.024m

(6) After-tax return on new $2.024 x 0.15 RM303,600

funds

(7) Revised earnings 1,380,000 + RM1,683,600

303,600

(8) Revised number of shares 2.3m +0.46m 2.76 million

(1mark) shares

(9) Revised earnings per share 1,683,600/ 2.76m RM0.61 or

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MAY 2022 TRIMESTER
TUTORIAL 5 (WEEK STARTING 21 FEB 2022)
EQUITY FINANCE (CHAPTER 4)

61sen

(10) Current earnings per share 1,380,000/ 2.3m RM0.60 or

60sen

(11) Current price/earnings ratio ($5.50 x 2.3m)/ 9.2 times

1.38m

(12) Assuming no change in 9.2 x 0.61 RM5.61

PER, NEW share price

(b) In corporate finance, a key concept is the relationship between risk

and return. The higher the risk associated with the investment, the
higher will be the return required in exchange for investing in it.
Bonds are debt finance paying a fixed annual return and are secured
on assets of the company. They therefore have a much lower risk
than ordinary equity, which is unsecured and which has no right to
receive a dividend. If the company fails, the ordinary shareholders
may receive nothing at all. In exchange for this higher risk, ordinary
shareholders will require a higher return.

QUESTION 3
SF Berhad wishes to increase its production capacity by purchasing additional
plant and equipment at a cost of RM3.8 million. The abridged profit and loss
account for the year ended 30th November 2016 is as follows:

RM million

Sales turnover 140.6

Profit before interest and taxation 8.4

Interest 6.8

Profit before tax 1.6

Taxation 0.4

Profit after taxation 1.2

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MAY 2022 TRIMESTER
TUTORIAL 5 (WEEK STARTING 21 FEB 2022)
EQUITY FINANCE (CHAPTER 4)

Earnings per share 15sen

In order to finance the purchase of the new plant and equipment, the directors
of the company have decided to make a rights issue equal to the cost of the
equipment. The shares are currently quoted on the stock exchange at
270sen per share and the new shares will be offered to shareholders at
190sen per share.
Required:
Calculate
(i) The theoretical ex-rights price per share
(ii) The value of the rights on each existing share.
(iii) Assuming the increase in production capacity will lead to an increase in
profit after tax of RM600,000 per annum and the price-earnings ratio (P/E
ratio) of the company will remain unchanged after the rights issue,
calculate the market value per share after the rights issue.

ANSWER

Number of shares in issue Total Earnings/EPS

1,200,000/0.15 8,000,000 shares

Value of existing shares 8,000,000 shares x RM2.70 RM21,600,000

Cash raised from new 2 million shares x RM1.90 RM3,800,000

shares

Total value after rights RM25,400,000

Number of shares issued RM3,800,000/RM1.90 2,000,000 shares

through rights issue

Form of rights 2,000,000/8,000,000 1 for 4

Total number of shares 8 million + 2 million 10 million shares

after rights issue

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MAY 2022 TRIMESTER
TUTORIAL 5 (WEEK STARTING 21 FEB 2022)
EQUITY FINANCE (CHAPTER 4)

Current value of 4 existing 4 shares x RM2.70 RM10.80

shares

Rights issue of 1 share 1 share x $1.90 RM1.90

Theoretical value of 5 RM12.70

shares

Theoretical ex-rights RM12.70/5 RM2.54

price

Current market value of RM2.70

existing share

Theoretical ex-rights price RM2.54

Rights issue price RM1.90

Value of a right (RM2.54 – RM1.90)/4 RM0.64 or RM0.16

Existing P/E ratio RM2.70/0.15 18 times

Revised profit after tax RM1.2 million + RM600,000 RM1.8 million

Revised total market value 18 (PER) x RM1.8 million RM32.4 million

Therefore, NEW market RM32.4 million/10 million RM3.24

value per share shares

QUESTION 4
C Berhad has 6,000,000 ordinary shares in issue and has been making
regular annual profits after tax of RM3,000,000 for some years. The current
share price is RM5.00. A proposal has been made to issue 2,000,000 new
shares in a rights issue at an issue price of RM4.50 per share. The funds
would be used to redeem RM9,000,000 of 12% debenture stock. The rate of
corporation tax is 33%. Assume that C Berhad’s P/E ratio remains
unchanged by the rights issue. Assume that the market is semi-strong

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EQUITY FINANCE (CHAPTER 4)

efficient and that details of the way in which the funds raised will be used are
included in the announcement of the rights issue?
What would be the predicted effect of the rights issue on the share price?
Would you recommend that the issue take place?

ANSWER
If the stock market shows semi-strong efficiency, the share price will change
on announcement of the rights issue, in anticipation of the change in EPS.
The current EPS is 50sen and so the current P/E ratio is 10.

RM

Current annual earnings 3,000,000

Increase in earnings after rights issue

Interest saved (12% x RM9,000,000) 1,080,000

Less tax on extra profits (33%) (356,400)

Anticipated annual earnings 3,723,600

Number of shares (6,000,000 + 2,000,000) 8,000,000

EPS 46.55sen

Current P/E ratio 10

Anticipated share price (If P/E 4.66 per

ratio stays the same share

The proposed share issue is 1 for 3, so we can estimate the theoretical ex

rights price

Current value of three shares 3 x 5.00 15.00

Rights issue price of one share 1 x 4.50 14.50

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 CORPORATE FINANCE (UKFF3013)
MAY 2022 TRIMESTER
TUTORIAL 5 (WEEK STARTING 21 FEB 2022)
EQUITY FINANCE (CHAPTER 4)

Theoretical value of four shares 19.50/4

ex rights

Theoretical ex rights price 4.875

Comment: The anticipated share price after redeeming the debentures

would be RM4.6545 per share, which is less than the theoretical ex rights
price. If the rights issue goes ahead and the P/E ratio remains at 10,
shareholders should expect a fall in share price below the theoretical ex
rights price, which indicates that there would be a capital loss on their
investment. The rights issue is for this reason NOT RECOMMENDED.

QUESTION 5
S Berhad is a small company which manufactures and distributes gymnastic
equipment, has been trading since 2X09. There are only few directors and
they owned all the shares. These directors are employed full time to manage
the business. It made sales of 100,000 units at an average wholesale price of
RM10 per unit during its last financial year ending 30 April 2X13. In 2X13-
2X14, the management has planned to introduce a new brand of equipment
which will be sold at a lower unit price to more price-sensitive market
segments. The introduction of the new brand is expected to raise total sales
by 15%. To support greater sales activity, it is expected that additional
financing, both long term capital and working capital, will be required. S
Berhad expects to make capital expenditures of RM1,060,000 in 2X13-2X14,
partly to replace worn-out equipment and purchase new equipment to support
the expected sales expansion. The directors proposed that 1 for 4 rights issue
should be made at a 20% discount to the current share price of RM2·30 per
share in order to reduce gearing and the financial risk of the company. You
may assume that all current assets and current liabilities will vary directly in
line with sales. S Berhad’s statement of financial position (balance sheet) for
the financial year ending 30 April 2X13 shows the following:

RM000 RM000

Non-current assets 1200

Current assets;

Inventories 160

Receivables 230

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 CORPORATE FINANCE (UKFF3013)
MAY 2022 TRIMESTER
TUTORIAL 5 (WEEK STARTING 21 FEB 2022)
EQUITY FINANCE (CHAPTER 4)

Cash 60 450

Total assets 1650

Equity and liabilities

Ordinary shares(50sen par value) 600

Retained profits 220

Total equity 820

Long term debt at 12% 600

Current liabilities

Trade payables 230

1650

Required:
a. Calculate the theoretical ex rights price per share, value of rights and the
amount of finance that would be raised from rights issue.
b. An investor owns 2,000 shares in S Berhad. The investor takes up his
rights. Determine and discuss the effect on his wealth.

SUGGESTED ANSWER
(a)

Current share price RM2.30

Rights issue price RM2.30 X 0.8 RM1.84

TERP (4 x 2.30) + (1 x RM1.84)/5 RM2.208

Value of rights =RM2.208-RM1.84 RM0.368

Amount of finance raised:

Number of shares 1,200,000/4 600,000shares

issued

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MAY 2022 TRIMESTER
TUTORIAL 5 (WEEK STARTING 21 FEB 2022)
EQUITY FINANCE (CHAPTER 4)

Cash raised 600,000shares x RM1.84 RM552,000

(b)

Investor entitle to buy 2000/4=500shares at RM1.84

Total investment in 500 x RM1.84 RM920

rights issue

Current value of 2000 2,000 x RM2.30 RM4,600

shares

Additional investment RM920

in rights issue

Total wealth before RM5,520

rights issue

After rights issue, total 2,500shares

share holding

Theoretical value of 2500 x RM2.208 RM5,520

2500 shares

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