Advanced financial management revision question and answer

EMC Ltd has a paid up share capital of 1.2 million shares of Sh.20 each. The current market price per share is Sh.36. The company has no loan capital. Maintainable earnings before tax are forecast at Sh.4.8 million. The company‟s effective tax rate is 40%. The company requires to raise a further Sh.15
million in order to achieve additional earnings of Sh.2.2 million per annum and proposes doing this means of a rights issue. Suggested alternative prices for the rights issue are Sh.32 and Sh.25 per share.

Required:
a) Calculate, when the price is Sh.32 per share, the theoretical market price per share of the enlarged capital after the issue (the ex-rights price) and also the market value of a right.

b) Calculate as in (a) above when the price is Sh.25 per share.

c) Suggest, with reasons, what issue price is most likely to be adopted the company.

d) What factors might, in practice, invalidate your calculations?
ANSWER
a) If issue price is Sh.32

c) Issue price to adopt
• A low issue price leads to high number of shares being issued which will lead to dilution in future EPS.
• A high issue price leads to few shares being issued thus less dilution in future EPS.
• Therefore the preferable issue price is Sh.32 since few shares are issued (468,750
shares) and thus lesser dilution in future EPS. The EPS is one of the critical variables which investors look for before making investment decisions.

d) The factors which might invalidate the calculation are as follows:
• If the cum-right MPS was to change
• If floatation costs associated with the issue are considered
• If all the shares are not subscribed for during the rights issue.

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