Evaluation of equity finance versus debt finance PXP plc is a listed company that has

Question

Evaluation of equity finance versus debt finance

PXP plc is a listed company that has made an offer of £3.20 per share for the ordinary share capital of VVM plc. Details of the two companies are as follows:

[latex]\begin{array}{lll} & ext { PXP } & ext { VVM } \& £ 000 & £ 000 \ ext { Ordinary shares (25p nominal value) } & 2,500 & 900 \ ext { Reserves } & {1,750} & \underline{1,000} \& \underline{4,250}&{\underline{1,900}} \ ext { Current ordinary share price }& ext{£5.10 per share}& ext{£2.50 per share}\ ext { After-tax cost of capital }& 9 ext { per cent } & 13 ext { per cent } \ ext{Current earnings per share} & 23 p & 19 p\end{array}[/latex]

PXP is not sure whether to finance the offer by a rights issue or by an issue of bonds. It expects that, after the acquisition, it will make savings in after-tax operating costs of £250,000 per year. PXP pays tax on profits at a rate of 30 per cent.
If the price/earnings ratio of PXP remains constant, calculate the post-acquisition share price of PXP under the following methods of finance and comment on the effect on the wealth of its shareholders:
1 a rights issue at an issue price of £4.00 per share;
2 an issue of 12 per cent bonds.

Accepted Answer

The post-acquisition market value of PXP, ignoring the financing method is as follows:

[latex]\begin{array}{lc}&£m\ ext { Current market value of PXP }=2.5 ext{m} imes 4 imes £ 5.10= & 51.00 \ ext { Current market value of WMM }=0.9 ext{m} imes 4 imes £ 2.50= & \underline{9.00} \ ext { Combined market value } &60.00\ ext{Less purchase price = 0.9m * 4 * £3.20 =} &\underline{11.52} \ ext { Market value of PXP before savings } & 48.48 \ ext { Present value of cost savings = 250,000/0.09 = } & \underline{2.78} \ ext { Post-offer market value of PXP } & \underline{51.26} \ ext { }\end{array}[/latex]

Financed by a rights issue

Number of shares issued = £ 11.52 m / 4.0 = 2.88 m
Total number of shares after acquisition = 10 m + 2.88 m = 12.88 m
PXP earnings before acquisition = 0.23 [latex] imes[/latex] 10 m = £ 2.30 m
VVM earnings before acquisition = 0.19 [latex] imes[/latex] 3.6 m = £ 0.68 m
Increase in earnings from cost savings = £ 0.25 m
Total earnings after acquisition = 2.30 m + 0.68 m + 0.25 m = £ 3.23 m

The post-acquisition market value can be found by multiplying the post-acquisition earnings by the P/E ratio.

P / E ratio before acquisition = 5.10 / 0.23 = 22 times
Post-acquisition market value = 3.23 m [latex] imes[/latex] 22 = £ 71.06 m
Post-acquisition share price = 71.06 m / 12.88 m = £ 5.52 per share
The theoretical ex-rights price is (51 m + 11.52 m ) / 12.88 m = £ 4.85 per share

Since the post-acquisition share price is greater than the theoretical ex-rights price per share, the wealth of PXP shareholders has increased.

Financed by a bond issue

The number of shares remains at 10 m
Post-acquisition earnings ignoring bond interest = £ 3.23 m
Interest on bonds = 11.52 m [latex] imes[/latex] 12% = £ 1.382 m
Tax saved = 1.382 m [latex] imes[/latex] 0.3 = £ 0.415 m
Decrease in earnings = 1.382 m - 0.415 m = £ 0.967 m
Post-acquisition earnings = 3.23 m - 0.967 m = £ 2.263 m
Post-acquisition market value = 2.263 m [latex] imes[/latex] 22 = £ 49.79 m
Post-acquisition share price = 49.79 m / 10 m = £ 4.98 per share

Since the post-acquisition share price is less than the current market price per share of £5.10, the wealth of PXP shareholders has decreased.

Conclusion
Financing by a rights issue can be recommended as it leads to an increase in the wealth of shareholders, while financing by an issue of bonds cannot be recommended.

Question 5.EX.9: Evaluation of equity finance versus debt finance PXP plc i...

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