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Finance III: Tutorial One
SOLUTIONS
Rights Issues
Q1. Balmorals is a well established company that has run into various difficulties in recent years. Its management has recently undertaken a review of its activities and has decided to proceed with a radical re-structuring of the business. To restore the company's financial stability it has been decided it will be necessary to raise £160 through a rights issue. Following discussions with its investment bankers the company has decided to make the rights issue and has to decide between two sets of terms. One possibility is to have an underwritten issue at a discount of 20 per cent to the current market price of £5.00. Alternatively the company could undertake a deep discount issue, setting the discount at 40 per cent, and avoid the underwriting expense. Some members of the Board of Directors have opposed a deep discount issue as it involves more dilution than an issue at a conventional discount. It has been argued that the deep discount issue will lower the share price and the earnings per share. The company has 100m shares outstanding and the level of expected earnings per annum after the issue is £99m.
a) For the two sets of terms determine the ex-rights price, the earnings per share, the earnings yield and the price-earnings ratio. Consider the earnings entitlement of a shareholder who owns 100 shares. Conventional Discount Initial Value of Equity = 100 m x £5.00 = £500m Funds required = F = £160m Subscription price = P (^) S =£5.00 (1- 0.2) = £4. Number of new shares = F/P (^) S =£160m/£4.00 = 40m Terms = New shares/Old Shares = 40/100 = 2 for 5
Ex-rights Price (Initial Value + New Funds)/Old shares + New shares = £4.
Theoretical Value of right = Ex–rights Price - Subscription Price = £4.
E(EPS) = Expected Earnings/Number of Shares = £99/140m = £0.7071m P 0 /E 1 = £4.7143/£0.7071 = 6.67 (price-earnings ratio) E/P 0 = £0.7071/£4.7143 = 0.15 (earnings yield)
100 old shares plus 40 new shares Total earnings = 140 x 0.7071 = £
Deep Discount Issue Initial Value of Equity = 100 m x £5.00 = £500m Funds required = F = £ 160m Subscription price = P (^) S = £5.00 (1 - 0.6) = £2. Number of new shares = F/P (^) S = £160m/£2.00 = 80m Terms = New shares/Old Shares = 80/100 = 4 for 5
Ex-rights Price (Initial Value + New Funds)/Old shares + New shares = £660m/180m = £3.
Theoretical Value of right = Ex – rights Price - Subscription Price = £3.67 – £ 2.00 = £ 1.
E(EPS) = Expected Earnings/Number of Shares = £99/180m = £0.55m P 0 /E 1 = £3.67/£0.55 = 6.67 (price-earnings ratio) E/P 0 = £0.55/£3.67 = 0.15 (earnings yield)
100 old shares plus 180 new shares Total earnings = 180 x 0.55 = £
No difference in earnings outcomes.
b) Comment on the position of the Board members who have expressed concerns about the dilution associated with the deep discount issue. The board members are failing to differentiate between the real and nominal impact of the issue. The fall in share price and earnings per share are compensated for by the larger number of shares held by a shareholder for the same cash outlay. The real value of the shareholder’s investment and expected earnings do not change as a result of the terms of the issue.
Consider an investor holding 9 shares and her reaction to first a conventional discount and then to a deep discount issue.
Purchase Additional Shares Conventional Discount Deep Discount
Initial Investment Initial Investment 9 shares at £2.50 = £22.50 9 shares at £2.50 = £22. Buy 3 more at £2.00 = £6.00 Buy 5 more at £1.20 = £6. Total investment = £28.50 Total investment = £28. Value of 12 shares at £2.375 (the ex-rights price)
= £28.50 Value of 14 shares at £2.
Change in wealth = 0 Change in wealth = 0
Sell Rights Conventional Discount Deep Discount
Initial Investment Initial Investment 9 shares at £2.50 = £22.50 9 shares at £2.50 = £22. Sell 3 rights at 37.5p = -1.125 Sell 5 rights at 83.57p = -4. Remaining Investment
Total investment = £18.
Value of 9 shares at £2.
Value of 9 shares at £2.
Change in wealth = 0 Change in wealth = 0
Question 3 SkyePharma SkyePharma, a drug company listed on the London Stock Exchange, announced on September 28 th^ 2005 a rights issue. The details of the issue, the market’s reaction, and the comments of the Financial Times are given below. Read the report from the Financial Times and using the information contained in the report answer the questions below.
“ Shares in SkyePharma fell almost 21 per cent yesterday after the drug reformulation company said it planned to raise £35m in a heavily discounted rights issue to fund the development of Flutiform, a key product.
Flutiform is a combination asthma drug that has completed Phase II clinical trials and is due to start Phase III trials. SkyePharma had been looking for a partner to help pay for the expensive Phase III trial stage, but said it would now shoulder Phase III development costs itself.
That would mean additional costs of £8m, although the company said it was continuing discussions over partnerships.
SkyePharma has spent a couple of years looking for a partner for Flutiform, which it says could eventually generate annual sales of $1bn (£566m) and that it hopes to launch in 2007. In April,SkyePharma had announced it was close to agreement with an unnamed pharmaceutical company for the US marketing and sales of Flutiform. But the deal, which would have been worth up to $160m, fell through.
The company is planning a one-for-five rights issue of 125.6m shares at 30p a share, a 43 per cent discount to the closing price on Monday (sept 26).
Pre-tax losses were £9.1m in the six months to June 30, compared with losses of £8.6m in the same period a year earlier. Revenue was £36m (£35.1m) and losses per share were 1.5p (losses of 1.4p). Shares in SkyePharma closed down 10¾p at 42p.
FT Comment SkyePharma's share price has suffered in the past from delays and false dawns in finding a partner for Flutiform. While going it alone on Phase III could mean better terms on a licensing deal, in the shorter term it means more expense and risk. While SkyePharma has other drugs in the works, the share price will benefit most from news of a Flutiform agreement. ” Financial Times Sept 29 th^2005
a) Determine the expected ex-rights price and the value of a right at the end of trading on September 28 th^ 2005. Assume that the price prior to the issue was 53p [ie, if 30p represents a discount of 43 per cent then the price prior to the issue is 30p/(1 – 0.43) = 52.63]. The price fell by 21 per cent on the announcement 53(1 – 0.21) = 41.58, approximately 42p. We will assume that this is the appropriate price for purposes of calculating the ex-rights value of the shares and the value of a right.
Px = (N 0 P 0 + ΔNPs)/(N 0 + ΔN) = (5 x 42p + 1 x 30p)/(5 + 1) = 40p V(R) = Px – P (^) s = 40p – 30p = 10p (Some flexibility should be shown in the evaluation of answers when candidates end up with different figures to those specified above as a result of assuming a price today different to 42p.)
b) Demonstrate that in principle a shareholder owning 100 shares will be equally well off from investing in the rights and selling the rights. Invest in Rights Investor owns 100 shares at 42p £42. Investor purchases 20 shares at 30p £6. Total Investment £48. Value of 120 shares at 40p (P (^) x ) £48. Change in shareholder wealth 0
Sell Rights Investor owns 100 shares at 42p £42. Sells 30 rights at 10p £2. Reduced investment in shares £40. Value of 100 shares at 40p (Px) £40. Change in shareholder wealth 0
