Which option the company should choose to raise the funding

Introduction
Koala Ltd is a large blue chip Australian diversified industrial company and first listed
on the Oldcastle Securities Exchange in 1994. As a diversified industrial the company
operates within sectors including retail, resources and financial services. In the mid
2000’s the company experienced a period of high growth and great success, and
took advantage of this success by making several large takeovers of competitors.
The company has 25,000 shareholders who own on average 200 shares in the
company each, and the current share price is $33.10 per ordinary share. The
majority of Koala Ltd’s shareholders are Australian residents for tax purposes. The
company’s debt ratio is currently 46%.
Recently there has been significant change both at the company and within sectors
that the company operates in.
The CEO of the last 15 years has retired and a new CEO has been appointed who is
still trying to “find his feet” at the company and has been asking a lot of questions of
the finance manager.
The retail industry has experienced slowing sales growth as online shopping
increases in popularity. The board of directors of Koala Ltd have decided that it
would be a good time to commence selling their retail products online in addition to
selling through current retail outlets. They have identified a company that is an
online retailer in direct competition with Koala Ltd’s retail business that they will
commence takeover proceedings to acquire.
The company needs to raise a minimum of $20,000,000 to finance the acquisition
and cover the acquisition-related costs. The finance manager has identified several
options to raise the required funding. These options are mutually exclusive so the
company must select only one option.
Option 1: a rights issue
The finance manager is aware that a rights issue could be used to raise the funding
required for this acquisition. The rights would be non-renounceable. After
consultation with the legal advisors the finance manager has learned that a
disclosure document (not as detailed as a full prospectus) would be required for this
rights issue. The cost of this disclosure document is significantly lower than
preparing a full prospectus.
The rights offer being considered is a 1 for 5 issue with a subscription price of
$26.50 per share. The company expects 75% of existing shareholders to subscribe
to the issue. The company does not intend to use the services of an underwriter for
this issue.
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Option 2: issue corporate bonds
The company can make a new issue of corporate bonds in order to raise the
required funds. The finance manager has been advised by the credit rating agency
that the rating given to the issue would be “BB”.
The corporate bonds that would be issued would be 10 year bonds with a face value
of $1,000 per bond paying interest at a rate of 8% per annum payable half yearly.
In appendix 1 you will find the current market yields for bonds of various credit
ratings.
Option 3: issue ordinary shares
The company can make a new issue of ordinary shares in order to raise the required
funds.
Koala Ltd just paid a total dividend of $2.45 per ordinary share this year. This
dividend will increase at 10% for the next 4 years, and then the growth rate will
drop to 7% per year indefinitely.
The required rate of return on ordinary shares is currently 18% per annum.
Required:
You work for an investment bank, Lake Macquarie Bank, and have been employed
as a consultant to the CEO of Koala Ltd to help with this important funding decision.
You must write a report of maximum 2,500 words to the new CEO of Koala Ltd
regarding the 3 options identified by the finance manager for raising the minimum
$20,000,000 necessary for the upcoming acquisition.
In your report you must discuss the advantages and disadvantages of each option
and the implications for current shareholders and current debt-holders (see the
marking criteria for more specific requirements). You must also make an overall
recommendation as to which option the company should choose to raise the funding
required for the acquisition. You must explain why this is an appropriate choice.