Q. Determine expected future cash flows?
A rights issue will be a smart source of finance to Tirwen plc as it will reduce the gearing of the company. The current debt/equity ratio by means of book values is
Debt/equity ratio = 100 × 4500/3500 = 129%
Including the overdraft debt/equity ratio = 100 × 5750/3500 = 164%
Both values are over the sector average of 100% and issuing new debt will not be attractive in this situation. A considerable reduction in gearing will take place however if the rights issue is used to redeem $2·5m of debentures
Debt/equity ratio = 100 × 2000/6000 = 33%
Including the overdraft debt/equity ratio = 100 × 3250/6000 = 54%
If the rights issue isn't used to redeem the debenture issue the decrease in gearing is less dramatic
Debt/equity ratio = 100 × 4500/6000 = 75%
Including the overdraft debt/equity ratio = 100 × 5750/6000 = 96%
In both cases the debt/equity ratio falls to below the sector average signalling a decrease in financial risk. The debt/equity ratio would drop further if increased retained profits were included in the computation but the absence of information on Tirwen's dividend policy makes retained profits uncertain.
If the rights issue is utilized to redeem $2·5m of debentures there will be an improvement in interest cover from 3·4 times (2127500/627500) which is below the sector average of 6 times to 6·5 times (2127500/327500) which is marginally better than the sector average.
Interest cover might as well increase if the funds raised are invested in profitable projects.
A rights issue will as well be attractive to Tirwen plc since it will make it more likely that the company can raise further debt finance in the future possibly at a lower interest rate due to its lower financial risk.
It must be noted that a decrease in gearing is likely to increase the average cost of the finance used by Tirwen plc since a greater proportion of relatively more expensive equity finance will be used compared to relatively cheaper debt. This will raise the discount rate used by the company and decrease the net present value of any expected future cash flows.