Financial management revision question and answer

Nakuru Bottlers Ltd. is a mineral water company based in Nakuru town. The company is listed on the Stock Exchange. Due to the huge demand for its products, the company is in the process of expanding its bottling facilities. The board of directors is undecided as to whether to have a rights issue or a placing on the stock exchange.

Required:
(i) Explain the meaning of a rights issue and list its advantages.
(ii) Explain the meaning of a stock placing and list its advantages.

(b) Nakuru Bottlers Ltd. can achieve a profit after tax of 20% on the capital employed. At present, its capital structure is as follows:
The directors propose to raise Sh.315,000,000 from a rights issue. The current market price is Sh.28.40 per share.

Required:
(i) Calculate the number of shares that must be issued if the rights issue price is Sh.25, Sh.23.40, Sh.21.50, Sh.26 and Sh.27.10.
(ii) Calculate the dilution in earning per share in each case.
ANSWER
(a) (i)Rights issue
Existing shareholders have a pre-emptive rights when new shares are issued. They exercise their rights in a rights issue. A rights issue will provide a way of raising new capital means of an offer to existing shareholders, inviting them to subscribe cash for new shares in proportion to their existing holdings. It can be made any type of company i.e. public, listed or unlisted.

Advantages:

Cheaper than offers for sale to the general public (low flotation costs)
 “Signaling” effects of higher profits in future.

More beneficial to the existing shareholders than issues to the general public
 Enables a firm to raise new finance

Relative voting rights are unaffected if shareholders take up their rights (no dilution)

(ii) Placing
This is an arrangement wherethe shares are not all offered to the public. Instead, the sponsoring maker (broker) arranges for most of the issue to be bought a small number of investors, usually institutional investors such as pension funds and insurance companies.

Advantages:

Cheaper as it involves a small number of shareholders (low flotation costs)
 It is possible to have shares sold to investors who are preferred.

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