Question

Rights issues

Carpets Direct Plc wishes to increase the number of its retail outlets in the South of England. The board of directors has decided to finance the expansion programme by raising the funds from existing shareholders through a 1 for 4 rights issue. The following is extracted from the most recent income statement of the business:

            Income Statement for the year ended 30 April

                                                                                                €m

Sales revenue                                                                          164.5

Operating profit                                                                    12.6

Interest                                                                                    (6.2)

Profit before taxation                                                                       6.4

Taxation                                                                                  (1.9)                                                                                       

Profit for the year                                                                  4.5

A €2million ordinary dividend had been paid in respect of the year.

The share capital consists of 120 million ordinary shares with a nominal value of €0.50 a share. These are currently being traded on the stock exchange at a price/earnings ratio of 22 times and the board of directors has decided to issue the new shares at a discount of 20% on the current market value.

Required:

1. Calculate the theoretical ex-rights price of an ordinary in Carpets Direct Plc.
2. Calculate the value of the rights for each ordinary share.
3. Identify and evaluate, at the time of the rights issue, each of the options arising from the rights issue to an investor who holds 4,000 ordinary shares before the rights announcement.

Answer 1

(a). Computation of Market price per share :

Earning per share * P/E multiple

=(4.50/120) * 22times

= 0.825/share

The formula for Theoretical ex-rights price of an ordinary share is:

[(New Shares*Issue price) + (Old shares*Market price)]/(Number of existing share + rights shares)

In the given question we have:

New shares = 120 million / 4

= 30 million rights shares

Issue price = current market price - 20% discount

=0.66

Old shares = 120 million

Market price = 0.825

Theoretical ex-rights price = [(30*0.66) + (120*0.825)]/120+30

= (19.80 + 99)/150

= 0.79 per share

(b). The formula for value of rights is :

Rp = (P0 - Ps)/(Ne +1)

where, Rp = Value of right

P0 = market price before rights issue

Ps = Rights subscription price

Ne = ratio of rights

(0.825 - 0.66)/4

= 0.041

(c). Effect on wealth of shareholder (if he sells entire rights):

Before rights: Value of 4000 shares (4000*0.825) = 3300

After rights : Value after rights issue (0.79*4000) = 3160

Add: Sale amount of rights(1000*0.041) = 41

Effect on wealth(Loss in value)    = 99

Effect on wealth of shareholder (if he does not take any action):

Before rights (4000*0.825) = 3300

After rights (4000 * 0.79) = 3160

Effect on wealth(Loss in value)    = 140

Since his loss is less in case of subscription of rights issue, hence he should avail option 1.