Chapter 11 • Gearing, the cost of capital and shareholders’ wealth
11.4 Mile Long Merchants Limited (MLM) runs two small supermarkets. MLM’s equity is
owned entirely by members of the Long family.
The directors are keen to open an additional supermarket. The cost of doing this
would be significant, perhaps equal to 30 per cent of the estimated current value of
the business. MLM generates profit at a level that leads to it paying corporation tax.
This is likely to continue.
The business has limited cash available because most of the surpluses of the past
few years have been distributed to the shareholders.
As finance director, you have been asked to prepare a paper to brief the other
directors on the key issues before the next board meeting, where the question of
finance to fund the additional supermarket will be discussed. The agenda for the
meeting states that the decision is between asking the business’s bankers to grant
a term loan to cover the projected expenditure, on the one hand, and seeking the
necessary funds from shareholders, through a rights issue, on the other.
Outline the main issues that you would include in your briefing paper.11.5*Ali plc is a Stock Exchange listed business. It is all-equity financed by 40 million 25p
ordinary shares, which are currently quoted at £1.60 each. In the recent past, annual
profit has been an average of £12.8 million. The average rate of return on capital
employed is expected to continue for the future. All of the profit is paid as a dividend
each year. The business intends to raise some finance for expansion, either through
a one-for-four rights issue at a price of £1.20 per share, or through the issue of 10 per
cent unsecured loan notes to raise the same amount of cash.
Lee is an individual who owns 10,000 of the shares.
Making the same assumptions as were made by Modigliani and Miller in their original
proposition on capital gearing (including a world without taxes), calculate and compare
the effect on Lee’s income of:
(a) personally borrowing the cash necessary to take up the rights; and
(b) the business deciding to make the loan notes issue instead of the rights issue.What general conclusion do you draw from this comparison?11.6 Cavendish plc is a Stock Exchange listed business whose main activity is producing
a low-value material used in large quantities in the building/construction industries.
Production is such that a large proportion of its costs are fixed relative to the level of
output.
The business is financed by a combination of ordinary shares and loan notes. At
present the capital gearing ratio is a little below the average for businesses in the
building materials industry.
Cavendish plc has identified a possible investment opportunity in taking over the
operation of a smaller business, Darley Ltd, which is involved in producing another,
more recently developed building material, which is increasingly being used as a sub-
stitute for a more traditional material. The decision has been taken to make the acquisi-
tion, and a price has been negotiated with the owners of Darley Ltd. The owners will
only accept cash as the consideration for the acquisition. The acquisition will expand
Cavendish plc’s total funds invested by around 20 per cent.
Cavendish plc does not have sufficient cash to be able to finance the acquisi-
tion without some form of fund raising. For various reasons, including potential loss
of the economies of scale in respect of issue costs, the directors have decided either
to make a rights issue of equities or a loan notes issue, rather than a combination of
the two.