Nogales Ltd Is Planning to Raise $100 Million to Finance

question 61

Multiple Choice

Nogales Ltd is planning to raise $100 million to finance its research and development program in the lucrative biotechnology division of the company.The company's internal forecasts for the year ended 30 June 2014 for selected accounts follow: $$\begin{array} { | l | l | } \hline \text { Total liabilities } & \$ 250 \text { million } \\\hline \text { Total shareholders' equity } & \$ 150 \text { million } \\\hline \text { Net income after tax } & \$ 10 \text { million } \\\hline\end{array}$$ There are 10 000 000 ordinary shares on issue.The entity has a debt covenant that debt-to-equity ratio be kept at less than two.
Three alternatives for funding the projects were considered by the board of directors:
Issue of ordinary shares equivalent to $100 million (equivalent to 5 million ordinary shares)
Issue of 10%,10-year non-convertible notes
Issue of 6%,preference shares (redeemable on 30 June 2024)
Which of the following statements made by a director is correct with respect to the three funding alternatives?

• A) The 10-year non-convertible notes issue will have no dilution effect and no impact on the company's debt covenant.
• B) Earnings per share will decline by one third with the issue of ordinary shares.
• C) The issue of preference shares will have no dilution effect and no impact on the company's debt covenant.
• D) Earnings per share will decline by one third with the issue of ordinary shares and the issue of preference shares will have no dilution effect and no impact on the company's debt covenant.

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