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Corporate Reconstruction and Re-organisationCorporate ReconstructionDebt-for-Equity SwapRights IssueGearing

ACCA · Question 03 · Corporate Reconstruction and Re-organisation

SECTION B: ADVISORY REPORT

OmniRetail Group (ORG) operates a large chain of traditional brick-and-mortar department stores. Due to changing consumer habits, ORG has suffered declining revenues and is currently facing a severe liquidity crisis. The Board wishes to pivot the business model entirely to an e-commerce platform, which requires an immediate capital injection of $40 million.

ORG is currently in breach of its debt covenants. The current capital structure is as follows:

  • Equity: 20 million ordinary shares trading at $1.50 per share.
  • Debt: $80 million of 8% unsecured bonds, currently trading at $60 per $100 nominal value.

Current Annual Earnings Before Interest and Tax (EBIT) is $10 million. The corporate tax rate is 20%.

The Board has proposed the following Capital Reconstruction Scheme:

  1. Debt-for-Equity Swap: Bondholders will be asked to exchange 50% of their nominal bond holdings ($40 million) for 25 million newly issued ordinary shares.
  2. Rights Issue: Following the swap, a rights issue will be launched to raise the required $40 million for the e-commerce pivot. The rights issue will be offered at a 20% discount to the theoretical ex-swap share price.

The Board estimates that the $40 million investment in e-commerce will increase annual EBIT by $6 million immediately.

REQUIREMENTS:

(a) Calculate the current Earnings Per Share (EPS) and the current gearing ratio (Debt / (Debt + Equity)) using market values. (4 marks)

(b) Assuming the reconstruction scheme is fully implemented:
(i) Calculate the theoretical share price immediately after the debt-for-equity swap.
(ii) Calculate the issue price of the rights shares and the number of shares to be issued.
(iii) Calculate the revised EPS and the revised market value gearing ratio. (12 marks)

(c) Evaluate the acceptability of the proposed reconstruction scheme from the perspective of:
(i) The existing bondholders.
(ii) The existing shareholders. (9 marks)

How to approach this question

1. Calculate current EPS by deducting interest and tax from EBIT, then dividing by shares. Calculate gearing using market values. 2. For the swap, add the market value of the cancelled debt to the equity value, then divide by the new total number of shares. 3. Calculate the rights issue price by applying the discount, then divide the required funds by this price to find the number of shares. 4. Recalculate EBIT, Interest, Tax, and divide by the final total number of shares for the new EPS. 5. Discuss the scheme logically: compare the 'with scheme' scenario to the 'without scheme' (liquidation) scenario for both parties.

Full Answer

Corporate reconstruction is required when a company is in financial distress. A debt-for-equity swap reduces the debt burden and interest payments, improving cash flow. However, it dilutes existing shareholders. The success of a reconstruction scheme depends on the principle of 'shared pain': both debt holders and equity holders must be better off under the scheme than they would be in a liquidation scenario.

Common mistakes

Using nominal values instead of market values for gearing calculations. Calculating the rights issue discount on the original $1.50 share price instead of the new ex-swap price. Forgetting to add the new EBIT from the e-commerce investment when calculating the revised EPS.
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