Question

Aussie Elder Care Ltd operates nursing homes. Its directors are Jan, Tony and Ben who hold 30% of the shares in the company. The directors allocate 1 million new shares to certain business associates. This has upset certain shareholders who claim that the share placement was made with a view to preventing a future takeover offer being made. The directors claim that the allotment was made to raise cash required for the company’s future needs. Advise the shareholders:

Is there any further information or assumptions you need to make?

How would you approach this question in an exam?

What structure would you adopt? What headings/ subheadings would you use?

What cases/ principles would you rely on?

What is your overall answer?

Answer 1

1. ASSUMPTION

Further assumption by the shareholders may be pertaining to the fact that if the justification provided by the company regarding need of additional funds is true then why not go for debt capital? Debt capital being a cheaper source of finance is more suitable to cater to the company's needs instead raising further capital which also increases the number of outstanding shares thereby causing a majority reduction in EPS for small shareholders in the company.

Company's existing debt as well as its debt paying capacity would be a major factor for consideration in case of this assumption.

2. INTRODUCTION

The case is about Aussie Elder Care Ltd operating nursing homes. The 3 directors are holding 30% shares of the company. And directors have issued new 1 million shares through private placement. The shareholder has raised concern regarding this but director are defended themselves by saying that it was done to raise the cash for company's future need.

From Company's viewpoint

They may have been done to reduce the chances of takeover and also can be called as next poison pills. This is also a defense tactics used by company.

From shareholder's viewpoint

According to them they could have gone for debt financing or any other method rather than issuing share through private placement.

3. OPTIMUM CAPIAL STRUCTURE: Many theories have circulated around capital structure but main focus of every theory remains maximizing the wealth of the existing shareholders thereby giving rise to optimum capital structure, i.e., a perfect mix of debt and equity in such a way that the value of the shares is maximized and maximum amount of returns can be attained for the shareholders at minimum cost of raising such capital.

DEBT: Debt is a long term source of financing. Debt though being the cheaper source of capital and its other benefits include tax savings for the company but these savings can only happen in case a company is able to make interest as well as monthly payments and still has sufficient amount of working capital available for conducting the day to day operations of the company.

EQUITY: Equity is another long term source and is referred to as a unit of the share capital containing some value and is subscribed by the public, thereby making them the shareholders. But increase in the equity shares also increases the floatation cost and the inside liability of the company.

OPTIMUM MIX: The main concern is to attain such a mix of debt and equity such that organizational as well as shareholders wealth can be maximized. This can be attained by careful analysis of various financial statements to choose which option is most viable source for the company.

4. Principles affecting capital structure:   

The simplicity of the mix must be such that it caters to the needs of shareholders as well as attains the goal of the business of maximizing a firm's value. Moreover a firm's flexibility to adapt to ever changing market environment also impacts the choice of debt or capital as these factors directly impact the costs of respective financing alternatives. Risk and floatation cost are the other two factors to be considered while choosing the appropriate capital structure.

5. CONCLUSION

Therefore it can be said that the company cannot justify the shareholders by mere explanation of additional funds requirements rather a detailed report relating to choice to be made while designing a capital structure and the reasons for such choices must be clearly justified.