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Omani Co is a stock exchange listed company that is concerned by its current level of debt finance. It plans to make a rights issue and to use the funds raised to pay off some of its debt. The rights issue will be at a 25% discount to its current ex-dividend share price of $8 per share and Omani Co plans to raise $300 million, all of the proceeds will be used to repay 9% bond to whatever extent possible. Omani Co believes that paying off some of its debt will not affect its price/earnings ratio, which is expected to remain constant.
Extracts of recent financial statements of Omani Co are attached below:
| STATEMENT OF PROFIT OR LOSS | |
| $'000 | |
| Revenue | 547,000 |
| Cost of sales | (458,400) |
| Profit before interest and tax | 88,600 |
| Interest | (31,500) |
| Profit before tax | 57,100 |
| Tax | (17,130) |
| Profit after tax | 39,970 |
| STATEMENT OF FINANCIAL POSITION | |
| $'000 | |
| Equity | |
| Ordinary shares ($1 nominal) | 75,000 |
| Retained earnings | 252,000 |
| 327,000 | |
| Long-term liabilities | |
| 9% bonds ($100 nominal) | 350,000 |
| 677,000 | |
The 9% bonds are currently trading at $120.00 per $100 bond and bondholders have agreed that they will allow Omani Co to buy back the bonds at this market value. Omani Co pays tax at a rate of 30% per year.
Requirements:
For a financial management report you are required to prepare an appendix covering following calculations:
- Calculate the theoretical ex rights price per share of Omani Co following the rights issue. (2 marks)
- Calculate the impact of the decision of using cash raised by the rights issue to buy back bonds on the EPS and share price of Omani Co (5 marks)
- Calculate the impact of the decision of using cash raised by the rights issue to buy back bonds on financial risk, measured as gearing (debt / equity) and interest cover of Omani Co. (3 marks)
Based on the appendix you have produced under requirement (a) discuss:
- Whether the decision to use proceeds of right share issue to repay loan is acceptable to the share holders and company overall considering risk and values.
- Comment on the belief that the current Price / Earnings ratio will remain constant after the right issue.
Discuss the dangers to a company of a high level gearing, including in your answer an explanation of the business risk and financial risk.
Answers submitted
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