Case Scenario:
The finance director of Jackson plc of Jackson plc has proposed that a rights issue is undertaken to put the company's finances on a sound basis. As a result of a decline in the company's share price the market value of its equity, its debt-equity ratio based on market values has increased significantly and stands well above its planned level. Two years ago when the company's share price was 250p the debt-equity ratio was below 0.5, but it is now 1.30. The company has 100m shares outstanding and the market price of its shares is 120p, giving its equity an aggregate value of £1.20 million compared with its debt of £1.56 million. It is planned to raise £45 million through the rights issue, with a subscription price set at a discount of 25 per cent to its current market price. The funds raised will be used to repay some of the company's borrowing. If the company does not reduce its debt it is likely to find it difficult to meet its interest payments over the next two years. The board of director is confident that they have implemented policies to restore the company's profitability but these will take two to three years to have a major impact.
a)
i. Specify the terms of the issue and determine the theoretical ex-rights price, assuming that the announcement of the issue does not affect the share price, and the value of a right.
ii. Demonstrate that in principle a shareholder who decides to
1. Invest in the new shares
2. Sell her rights
Will not lose or gain from the transaction.
iii. Evaluate the contention that as the company's share price is well below its level two years ago this is not an appropriate time to undertake a new issue.
iv. Explain the view that even if the market can be expected to be surprised by the extent of the company's need for cash, and to react to the announcement by reducing the share price, it is still in the interests of the shareholders to proceed with the issue as long as the market price exceeds the subscription price.
b) Explain and assess the contention that a rights issue protects the interests of shareholders.