Business finance : theory and practice

Problems
A board meeting has been scheduled to make a decision as to the means of
financing the acquisition. In advance of the meeting, individual directors of Cavendish
plc have made the following comments:
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Director A: ‘We don’t want to make a rights issue of equities at present. With this
depression in the construction industry dragging our share price down, we are
going to have to issue a lot of shares to get the amount needed.’
Director B: ‘The trouble with a loan notes issue is that it will push our gearing level
above the sector average and that won’t help our share price.’
Director C: ‘My daughter is taking a business finance course as part of her degree,
and she has told me that there’s a theory that it doesn’t make any difference to
the existing shareholders whether new finance is raised from a share issue or by
borrowing.’
Prepare some notes that will brief the directors, in advance of the meeting, on the
likely key issues that they will need to consider, including the points that have already
been made to you.
11.7 Arthur Graham plc (AG) is a Stock Exchange listed business that owns a chain of
builders’ merchants throughout the south of England. AG is currently financed principally
by equity, as a result of organic growth.
An opportunity has arisen for AG to purchase all of the shares of an unlisted business,
Sandboy Ltd, which owns a chain of builders’ merchants with branches in many
locations in the Midlands, an area into which AG’s directors wish to expand. The price
being asked by the shareholders equals about 25 per cent of AG’s market capitalisation.
Given the price and the prospects for Sandboy, the directors of AG are keen to
acquire the shares. The scale of the investment is such that AG could not raise the
cash from internal sources and will have to make a rights issue of ordinary shares, an
issue of preference shares or a loan notes issue. A decision now needs to be made
on the method of funding.
Three of the directors have spoken to you about the funding decision and their
comments have included the following:
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Director A: ‘I’m not keen on borrowing because the interest will inevitably reduce
our earnings per share and, therefore, our share price.’
Director B: ‘I don’t favour a rights issue because inevitably many of our shareholders
don’t want to increase their investment and will lose out as a result.
Irrespective of the direct effects of a rights issue on our share price, this will have
an adverse effect on the total market value of our company. An issue of loan notes
seems the best idea.’
Director C: ‘I favour a preference share issue, because it would be neutral as far as
the capital gearing question is concerned; it will neither increase it nor reduce it.’
A board meeting has been arranged at which a final decision on the acquisition
of Sandboy and, most importantly, the means of funding it will be discussed. As
finance director, you have been asked to provide a briefing note for the directors to
read in preparation for this meeting. Your briefing note should raise all relevant points
about the funding arrangements and the points raised by the directors. The briefing
note must be in simple, non-technical language. All of the relevant factors must
be clearly explained and placed in the context of the particular circumstances of the
question.
Prepare the briefing note requested by the directors.
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