FIN2101 BUSINESS FINANCE II MODULE 6- SOURCES OF FINANCE QUESTION 1 What are the two most important characteristics of trade credit as a source of short-term finance? here does management's d iscretion lie in the use of trade cred it? QUESTION 2 What inducement would there be for a new customer buying $10 000 worth of product to take advantage of the discount if terms of 2.5/30, n/60 were offered ie what is the cost of not taking the discount? Assume 365 days per year QUESTION 3 Why is delay ing payment to suppliers and foregoing discounts offered often an expensive form of finance? Illustrate for a company with a 20% overdraft rate in receipt of a $10 000 invoice on which 3/7, n/30 discount terms have been offered, ie what is the cost of foregoing the discount? Assume 365 days per year QUESTION 4 Explain the ad vantages and disadvantages of the short- term funding strategy of"stretching accounts payable QUESTION 5 Why might a company prefer to use a temporary 3-month overdraft facility of $100 000 costing 20% per annum instead of a fixed 90-day loan costing 18% per annum? QUESTION 6 What is the essential difference between a commercial bill and a promissory note? QUESTION 7 What are the advantages( to the company) of a private placement of ordinary shares? Why might existing shareholders dislike or object to such an issue?
September 2003 FIN2101 BUSINESS FINANCE II MODULE 6 - SOURCES OF FINANCE QUESTION 1 What are the two most important characteristics of trade credit as a source of short-term finance? Where does management's discretion lie in the use of trade credit? QUESTION 2 What inducement would there be for a new customer buying $10 000 worth of product to take advantage of the discount if terms of 2.5/30, n/60 were offered, ie what is the cost of not taking the discount? Assume 365 days per year. QUESTION 3 Why is delaying payment to suppliers and foregoing discounts offered often an expensive form of finance? Illustrate for a company with a 20% overdraft rate in receipt of a $10 000 invoice on which 3/7, n/30 discount terms have been offered, ie what is the cost of foregoing the discount? Assume 365 days per year. QUESTION 4 Explain the advantages and disadvantages of the short-term funding strategy of "stretching" accounts payable. QUESTION 5 Why might a company prefer to use a temporary 3-month overdraft facility of $100 000 costing 20% per annum instead of a fixed 90-day loan costing 18% per annum? QUESTION 6 What is the essential difference between a commercial bill and a promissory note? QUESTION 7 What are the advantages (to the company) of a private placement of ordinary shares? Why might existing shareholders dislike or object to such an issue?
QUESTION 8 Bailey Shoes Limited has 3 million ordinary $1 shares on issue and has decided to make a 1 for-3 renounceable rights issue at $1.85 to finance expansion into the Perth and Brisbane markets. The issue will be underwritten by Ware Partners for $40 000. Immediately following the announcement of the issue, Bailey Shoes shares were trad ing at $2.25 (a) What is the theoretical value of the right to one new share and the theoretical value of Baileys shares ex rights? (b) How much will Bailey Shoes raise by the issue, assuming that the issue is fully subscribed? QUESTION 9 A company with a paid up capital of 1 million shares wishes to raise $12 million by way of a rights issue. The shares are currently sell ing at $84 each and the intended subscription price is $60 per share. Calculate (a) The number of shares to be issued (c) The theoretical value of the right to one new share one share under the rights issue (b) The number of shares needed to be held to purchas (d) The theoretical value of one share ex rights QUESTION 10 Hargar Ltd has decided to issue add itional ordinary shares through a rights issue. Hangar has 90 million ordinary shares issued and plans to issue an additional 10 million shares on the basis of a 1-for-9 rights issue, at a subscription price of $2 per share. If Hargar's cum rights price is $4.50, determine the following (a) How much does Hangar intend to raise? (b) Joe Seff is currently a shareholder of Hargar. How many shares must Joe hold to get one new share (c) What is the theoretical value of a right? (d) What is the share's theoretical price ex rights? (e) How much do you expect the share's price to drop on the ex rights date? Why? (f Joe Seff currently owns 90 Hargar shares. How many shares will he hold if he accepts the rights issue? How does the rights issue affect his wealth? (g) If Hargar had decided on an exercise price of $4 per share to raise the desired level of funds. what would have been the cond it ions of the rights issue? what would have happened to the share's theoretical ex rights price and the theoretical value of a right? (Assume that the amount of funds to be raised is unchanged)
September 2003 QUESTION 8 Bailey Shoes Limited has 3 million ordinary $1 shares on issue and has decided to make a 1- for-3 renounceable rights issue at $1.85 to finance expansion into the Perth and Brisbane markets. The issue will be underwritten by Ware Partners for $40 000. Immediately following the announcement of the issue, Bailey Shoes shares were trading at $2.25. (a) What is the theoretical value of the right to one new share and the theoretical value of Bailey's shares ex rights? (b) How much will Bailey Shoes raise by the issue, assuming that the issue is fully subscribed? QUESTION 9 A company with a paid up capital of 1 million shares wishes to raise $12 million by way of a rights issue. The shares are currently selling at $84 each and the intended subscription price is $60 per share. Calculate: (a) The number of shares to be issued. (b) The number of shares needed to be held to purchase one share under the rights issue. (c) The theoretical value of the right to one new share. (d) The theoretical value of one share ex rights. QUESTION 10 Hargar Ltd has decided to issue additional ordinary shares through a rights issue. Hargar has 90 million ordinary shares issued and plans to issue an additional 10 million shares on the basis of a 1-for-9 rights issue, at a subscription price of $2 per share. If Hargar's cum rights price is $4.50, determine the following: (a) How much does Hargar intend to raise? (b) Joe Seff is currently a shareholder of Hargar. How many shares must Joe hold to get one new share? (c) What is the theoretical value of a right? (d) What is the share's theoretical price ex rights? (e) How much do you expect the share's price to drop on the ex rights date? Why? (f) Joe Seff currently owns 90 Hargar shares. How many shares will he hold if he accepts the rights issue? How does the rights issue affect his wealth? (g) If Hargar had decided on an exercise price of $4 per share to raise the desired level of funds, what would have been the conditions of the rights issue? What would have happened to the share's theoretical ex rights price and the theoretical value of a right? (Assume that the amount of funds to be raised is unchanged)
FIN2101 BUSINESS FINANCE II SOLUTIONS TO TUTORIAL QUESTIONS MODULE 6-SOURCES OF FINANCE
September 2003 FIN2101 BUSINESS FINANCE II SOLUTIONS TO TUTORIAL QUESTIONS MODULE 6 - SOURCES OF FINANCE
QUESTION 1 Trade cred it. as a source of short-term finance is readily available, and virtually free insofar as there is no explicit charge associated with it Managements discretion lies in the timing of the payment, rather than the amount of credit which depends on the magnitude of purchases and cred it terms offered by suppliers QUESTION 2 Cost 100%CD N 2 100 0.31Dr31.20% The customer would need to find a risk-free investment that would turn $9 750 into $10 000 in 30 days. The return on such an investment would need to be 31.20% QUESTION 3 365 100%CD N 365 100323 =0.49dr49.10% The cost of foregoing the discount is 49.10% per annum, compared to the cost of the overdraft of 20%
September 2003 QUESTION 1 Trade credit, as a source of short-term finance, is: • readily available, and • virtually free insofar as there is no explicit charge associated with it. Management’s discretion lies in the timing of the payment, rather than the amount of credit which depends on the magnitude of purchases and credit terms offered by suppliers. QUESTION 2 0 .3 1 2o r 3 1 .2 0 % 3 0 365 100- 2 .5 2 .5 N 365 100%- CD CD Co st = = = The customer would need to find a risk-free investment that would turn $9 750 into $10 000 in 30 days. The return on such an investment would need to be 31.20%. QUESTION 3 0 .4 9 1o r 4 9 .1 0 % 2 3 365 100- 3 3 N 365 100%- CD CD Co st = = = The cost of foregoing the discount is 49.10% per annum, compared to the cost of the overdraft of 20%
QUESTION 4 Advantage Increased financing Disadvantages Cost of discounts foregone Possible deterioration of cred it rating Possible refusal of future supply/credit Fees/charges for late payment QUESTION 5 For the following reasons A fixed-term loan is likely to be for a specific purpose, whereas the overdraft allows for discretionary use(within reason) The overdraft may be used according to needs and interest is charged accord ing to use, ie the whole $100 000 need not be used. Note. however that fees are often charged on the unused portion of overdraft An overdraft may become a relatively long-term source of funds up to the limit, once established. It should be noted. however. that overdrafts are at call and not fixed term QUESTION 6 For a commercial bill, the acceptor, the discounter and any party which endorses the bi assume liability for repayment of the bill. This is referred to as a contingent liability For a promissory note, the borrower is the liable party, irrespective of how many times the note has been traded
September 2003 QUESTION 4 Advantage: Increased financing. Disadvantages: Cost of discounts foregone. Possible deterioration of credit rating. Possible refusal of future supply/credit. Fees/charges for late payment. QUESTION 5 For the following reasons: • A fixed-term loan is likely to be for a specific purpose, whereas the overdraft allows for discretionary use (within reason). • The overdraft may be used according to needs and interest is charged according to use, ie the whole $100 000 need not be used. Note, however, that fees are often charged on the unused portion of overdrafts. • An overdraft may become a relatively long-term source of funds up to the limit, once established. It should be noted, however, that overdrafts are at call and not fixed term. QUESTION 6 For a commercial bill, the acceptor, the discounter and any party which endorses the bill assume liability for repayment of the bill. This is referred to as a contingent liability. For a promissory note, the borrower is the liable party, irrespective of how many times the note has been traded
QUESTION 7 a private placement of ord inary shares is an issue of shares to institutional investors, such as life insurance companies. The benefits of a private placement are total issue costs are smaller given that there is no need for a prospectus and the issue is not the issue is completed more quickly with the ad vantage that the proceeds are rece erve earlier the directors can issue shares to entities which support them, thus strengthening their own Shareholders may object to a private placement because a private placement reduces their holding in the company(dilution of power); a rights issue would give them the opportunity to make a profit
September 2003 QUESTION 7 A private placement of ordinary shares is an issue of shares to institutional investors, such as life insurance companies. The benefits of a private placement are: • total issue costs are smaller given that there is no need for a prospectus and the issue is not usually underwritten; • the issue is completed more quickly with the advantage that the proceeds are received earlier; • the directors can issue shares to entities which support them, thus strengthening their own positions. Shareholders may object to a private placement because: • a private placement reduces their holding in the company (dilution of power); • a rights issue would give them the opportunity to make a profit
QUESTION 8 (a) Theoretical value of a right N (M-S) (S 3+1 $0.30 Theoretical value of shares"ex rights (N xM)+S N+1 (3×S22F+$1.8 $2.15 (b) Funds raised by the rights issue (1 million shares x $1.85)-$40000 I810000
September 2003 QUESTION 8 (a) Theoretical value of a right: ( ) ( ) = $ 0 . 3 0 3 + 1 3 $ 2 . 2 5- $ 1 . 8 5 = N + 1 N M - S R = Theoretical value of shares “ex rights”: ( ) ( ) = $ 2 .1 5 3 + 1 3 $ 2 .2 5+ $ 1 .8 5 = N + 1 N M + S X = (b) Funds raised by the rights issue: = (1 million shares ×$1.85) - $40 000 = $1 810 000
QUESTION 9 (a)$12000000÷$60 200 000 shares (b)1000000÷200000 5 shares, ie a l-for- rights issue N+1 5(S84s60 $20.00 (d (N×M)+ S84+$60 80.00
September 2003 QUESTION 9 (a) $12 000 000 $60 = 200 000 shares. (b) 1 000 000 200 000 = 5 shares, ie a 1-for-5 rights issue. (c) ( ) ( ) = $ 2 0 . 0 0 5 + 1 5 $84- $60 = N + 1 N M - S R = (d) ( ) ( ) = $ 8 0 . 0 0 5 + 1 5 $84 + $60 = N + 1 N M + S X =
QUESTION 10 (a) 10 000 000 shares x $2 $20000000 (b) 9 shares, ie a 1-for-9 rights issue (c) R N+1 9(450920 9+1 25 (d) N×M)+S (9×$4.5外+$2.0 (e) In theory, the price should drop by 25 cents(from $4.50 to $4.25) because of dilution If the rights issue conveys new information to the market, the drop may vary from 25 cents
September 2003 QUESTION 10 (a) 10 000 000 shares ×$2 = $20 000 000. (b) 9 shares, ie a 1-for-9 rights issue. (c) ( ) ( ) = $ 2 . 2 5 9 + 1 9 $ 4 . 5 0- $ 2 . 0 0 = N + 1 N M - S R = (d) ( ) ( ) = $ 4 . 2 5 9 + 1 9 $ 4 . 5 0+ $ 2 . 0 0 = N + 1 N M + S X = (e) In theory, the price should drop by 25 cents (from $4.50 to $4.25) because of dilution. If the rights issue conveys new information to the market, the drop may vary from 25 cents
QUESTION 10 (Continued) Joe will hold a total of 100 shares if he takes up his rights to 10 add itional shares, but his overall wealth position will be unchanged Cum rights position 90 shares @ $4.50 $405 Ex rights position 100 shares(@$4.25 $425 Increase in wealth 20 Less: Subscription costs 10 shares $2 Net wealth increase (g)$2000000÷$4 5 million shares to be issued 90000000÷5000000 18,:. a l-for-18 rights issue Theoretical value of shares"ex rights (N×M)+S (18×$4.5,+$4.0( 18+1 s4.47 Theoretical value of a right N (M-S) 18(S4.59s4.00 $0.47
September 2003 QUESTION 10 (Continued) (f) Joe will hold a total of 100 shares if he takes up his rights to 10 additional shares, but his overall wealth position will be unchanged: Cum rights position 90 shares @ $4.50 $405 Ex rights position 100 shares @ $4.25 $425 Increase in wealth $ 20 Less: Subscription costs 10 shares @ $2 $ 20 Net wealth increase $ 0 (g) $20 000 000 $4 = 5 million shares to be issued. 90 000 000 5 000 000 = 18, a 1-for-18 rights issue. Theoretical value of shares “ex rights”: ( ) ( ) = $ 4 . 4 7 1 8+ 1 1 8 $ 4 . 5 0+ $ 4 . 0 0 = N + 1 N M + S X = Theoretical value of a right: ( ) ( ) = $ 0 . 4 7 1 8+ 1 1 8 $ 4 . 5 0- $ 4 . 0 0 = N + 1 N M - S R =