Section C - Constructed Response

GreenYield Co is an agri-tech firm that has developed a new automated irrigation system. To fund the mass production and a permanent increase in working capital, the company needs to raise $20 million.

Current financial position:

• Ordinary shares in issue: 10 million
• Current share price: $5.00
• Profit Before Interest and Tax (PBIT): $8 million
• Current long-term debt: $10 million (paying 5% interest)
• Corporation tax rate: 25%

The board is considering two financing options:
Option 1: A rights issue at a 20% discount to the current market price.
Option 2: A new bank loan at an interest rate of 8% per annum.

Assume the new funds will immediately generate an additional $3 million in PBIT.

Required:
(a) For Option 1 (Rights Issue):
(i) Calculate the issue price per share and the number of new shares to be issued. (3 marks)
(ii) Calculate the Theoretical Ex-Rights Price (TERP). (3 marks)

(b) Calculate the expected Earnings Per Share (EPS) and Interest Cover ratio for BOTH Option 1 and Option 2. (8 marks)

(c) Discuss the relative merits of aggressive versus conservative working capital financing policies, and advise which policy GreenYield Co appears to be adopting by seeking long-term finance for its working capital needs. (6 marks)

Part (a) Rights Issue Calculations: (i) Issue Price = $5.00 * (1 - 0.20) = $4.00. Funds required = $20,000,000. Number of new shares = $20,000,000 / $4.00 = 5,000,000 shares. (This is a 1-for-2 rights issue: 5m new for 10m existing). (ii) Theoretical Ex-Rights Price (TERP): Value of existing shares = 10m * $5.00 = $50m Value of new funds = 5m * $4.00 = $20m Total theoretical value = $70m Total shares = 15m TERP = $70m / 15m = $4.67 per share. Part (b) EPS and Interest Cover: New PBIT = $8m + $3m = $11m. Current Interest = $10m * 5% = $0.5m. Option 1 (Rights Issue): PBIT: $11.00m Less Interest: ($0.50m) (unchanged) Profit Before Tax: $10.50m Less Tax (25%): ($2.625m) Earnings: $7.875m Number of shares: 15m EPS = $7.875m / 15m = $0.525 (or 52.5 cents) Interest Cover = PBIT / Interest = 11.0 / 0.5 = 22 times. Option 2 (Bank Loan): New Interest = $20m * 8% = $1.6m. Total Interest = $0.5m + $1.6m = $2.1m. PBIT: $11.00m Less Interest: ($2.10m) Profit Before Tax: $8.90m Less Tax (25%): ($2.225m) Earnings: $6.675m Number of shares: 10m (unchanged) EPS = $6.675m / 10m = $0.6675 (or 66.8 cents) Interest Cover = PBIT / Interest = 11.0 / 2.1 = 5.2 times. Part (c) Working Capital Financing Policies: An aggressive policy finances all fluctuating current assets and a portion of permanent current assets with short-term debt (like overdrafts). This is highly profitable (short-term debt is usually cheaper) but highly risky (renewal risk, interest rate risk). A conservative policy finances all permanent current assets and a portion of fluctuating current assets with long-term finance (equity or long-term loans). This is less profitable (long-term finance is more expensive) but very low risk. A matching policy finances permanent assets with long-term finance and fluctuating assets with short-term finance. GreenYield Co is seeking $20m to fund 'mass production and a permanent increase in working capital'. By using either a rights issue (equity) or a long-term bank loan to fund this permanent increase, GreenYield is adopting a matching (or slightly conservative) policy. This is prudent, as funding a permanent need with a short-term overdraft would expose the company to significant liquidity risk.