Cave plc is a Stock Exchange listed business whose main activity is producing a low-value material used in large quantities in the…

Cave 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.

Cave plc has identified a possible investment opportunity in taking over the operation of a smaller business, Darling Ltd, which is involved in producing another, more recently developed building material, which is increasingly being used as a substitute for a more traditional material.

The decision has been taken to make the acquisition, and a price has been negotiated with the owners of Darling Ltd. The owners will only accept cash as the consideration for the acquisition.

The acquisition will expand Cave plc’s total funds invested by around 20 per cent. Cave plc does not have sufficient cash to be able to finance the acquisition 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.

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 Cave plc have made the following comments:

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: ‘One of my children is taking a business finance course as part of their degree, and they have 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.’

Required

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. 

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