Question 7.SE.7: Carpets Direct plc wishes to increase the number of its reta...
Carpets Direct plc wishes to increase the number of its retail outlets. The board of directors has decided to finance this expansion programme by raising the funds from existing shareholders through a one-for-four rights issue. The most recent income statement of the business is as follows:
| 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 |
| Tax | (1.9) |
| Profit for the year | 4.5 |
An ordinary dividend of £2.0 million was proposed and paid during the year.
The share capital of the business consists of 120 million ordinary shares with a nominal value of £0.50 per share. The shares of the business 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 per cent on the current market value.
Required:
(a) Calculate the theoretical ex-rights price of an ordinary share in Carpets Direct plc.
(b) Calculate the price at which the rights in Carpets Direct plc are likely to be traded.
(c) 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.
Carpets Direct plc
(a) The stages in calculating the theoretical ex-rights price of an ordinary share are as follows:
(i) Earnings per share
\frac{Profit for the year}{No. of ordinary shares} = \frac{£4.5 m}{120 m} = £0.0375
(ii) Market value per share
Earnings per share × P/E ratio = £0.0375 × 22 = £0.825
(iii) For the theoretical ex-rights price
| £ | |
| Original shares (4 × £0.825) | 3.30 |
| Rights share (80% × £0.825) | 0.66 |
| Value of five shares following rights issue | 3.96 |
| Value of one share following the rights issue | \frac{£3.96}{5} |
| Theoretical ex-rights price | = 79.2p |
(b) The price at which the rights are likely to be traded is derived as below:
| Value of one share after rights issue | 79.2p |
| Less Cost of a rights share | (66.0p) |
| Value of rights to shareholder | 13.2p |
(c) Comparing the three options open to the investor:
(i) Option 1: Taking up rights issue
| £ | |
| Shareholding following rights issue ((4,000 + 1,000) × 79.2p) | 3,960 |
| Less Cost of rights shares (1,000 × 66p) | (660) |
| Shareholder wealth | 3,300 |
(ii) Option 2: Selling the rights
| £ | |
| Shareholding following rights issue (4,000 × 79.2p) | 3,168 |
| Add Proceeds from sale of rights (1,000 × 13.2p) | 132 |
| Shareholder wealth | 3,300 |
(iii) Option 3: Doing nothing
As the rights are neither purchased nor sold, the shareholder wealth following the rights issue will be:
| £ | |
| Shareholding (4,000 × 79.2p) | 3,168 |
We can see that the investor will have the same wealth under the first two options. However, if the investor does nothing the rights issue will lapse and so the investor will lose the value of the rights and will be worse off.