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Bar Co (12/11, amended)

Bar Co is a stock exchange listed company that is concerned by its current level of debt finance. It plans to make a rights issue and to use the funds raised to pay off some of its debt. The rights issue will be at a 20% discount to its current ex dividend share price of $7.50 per share and Bar Co plans to raise $90m. Bar Co believes that paying off some of its debt will not affect its price/earnings ratio, which is expected to remain constant.

STATEMENT OF PROFIT OR LOSS INFORMATION

 

$m

Revenue

472.0

Cost of sales

423.0

Profit before interest and tax

49.0

Interest

10.0

Profit before tax

39.0

Tax

11.7

Profit after tax

27.3

STATEMENT OF FINANCIAL POSITION INFORMATION

 

$m

Equity

 

Ordinary shares ($1 nominal)

60.0

Retained earnings

80.0

 

140.0

Long-term liabilities

 

8% bonds ($100 nominal)

125.0

 

265.0

The 8% bonds are currently trading at $112.50 per $100 bond and bondholders have agreed that they will allow Bar Co to buy back the bonds at this market value. Bar Co pays tax at a rate of 30% per year.

Required

A. Calculate the theoretical ex-rights price per share of Bar Co following the rights issue.
B. Calculate and discuss whether using the cash raised by the rights issue to buy back bonds is likely to be financially acceptable to the shareholders of Bar Co, commenting in your answer on the belief that the current price/earnings ratio will remain constant.
C. Calculate and discuss the effect on the financial risk of Bar Co of using the cash raised by the rights issue to buy back bonds, as measured by its interest coverage ratio and its book value debt to equity ratio.

D. Discuss the dangers to a company of a high level of gearing, including in your answer an explanation of the following terms:

(i) Business risk
(ii) Financial risk

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