Question 22 (Group 21 & 22) Underworld plc is a manufacturer of computer games. It is currently financed by a mixture of debt and equity as follows: Book value 1 million £1 ordinary shares Retained earnings 10,000 £100 9.5% iredeemable debentures £000s 1,000 1,978 1,000 Loan repayable in 2025 at 16% fixed interest rate 250 The market price of ordinary shares is £3.35, and the debentures have a market price of £94. The company pays corporation tax at a rate of 20%. The current return on government securities is 4%, the average stock market rate of return is 8% and the company has a beta value of 1.25. An opportunity has arisen to acquire Freshco Limited, a small company operating in the same industry. It is forecast that Freshco Ltd will generate a cashflow of £300,000 in the first year following acquisition. This is forecast to increase by 10% a year for the next four years after which cash flows will decline to £350,000 for the next two years. Due to the dynamic, constantly changing nature of this sector, cash flows after this are considered too unreliable to forecast. Freshco Ltd has 1.5 million ordinary shares currently trading on the stock market at a price of 85 pence each. It also has debt of £500,000. The directors of Underworld Plc use the company's weighted average cost of capital to appraise investment opportunities. Required: (a) Calculate Underworld's weighted average cost of capital (WACC). (b) Using discounted cash flows and Underworld's WACC, calculate the total business value and shareholder value of Freshco Ltd. (c) Based on your calculations recommend, with reasons, whether Underworld Plc should purchase Freshco Ltd. (d) State any assumptions that you have made in arriving at your answers to parts (a) and (b)
Question 22 (Group 21 & 22) Underworld plc is a manufacturer of computer games. It is currently financed by a mixture of debt and equity as follows: Book value 1 million £1 ordinary shares Retained earnings 10,000 £100 9.5% iredeemable debentures £000s 1,000 1,978 1,000 Loan repayable in 2025 at 16% fixed interest rate 250 The market price of ordinary shares is £3.35, and the debentures have a market price of £94. The company pays corporation tax at a rate of 20%. The current return on government securities is 4%, the average stock market rate of return is 8% and the company has a beta value of 1.25. An opportunity has arisen to acquire Freshco Limited, a small company operating in the same industry. It is forecast that Freshco Ltd will generate a cashflow of £300,000 in the first year following acquisition. This is forecast to increase by 10% a year for the next four years after which cash flows will decline to £350,000 for the next two years. Due to the dynamic, constantly changing nature of this sector, cash flows after this are considered too unreliable to forecast. Freshco Ltd has 1.5 million ordinary shares currently trading on the stock market at a price of 85 pence each. It also has debt of £500,000. The directors of Underworld Plc use the company's weighted average cost of capital to appraise investment opportunities. Required: (a) Calculate Underworld's weighted average cost of capital (WACC). (b) Using discounted cash flows and Underworld's WACC, calculate the total business value and shareholder value of Freshco Ltd. (c) Based on your calculations recommend, with reasons, whether Underworld Plc should purchase Freshco Ltd. (d) State any assumptions that you have made in arriving at your answers to parts (a) and (b)
Chapter1: Financial Statements And Business Decisions
Section: Chapter Questions
Problem 1Q
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Transcribed Image Text:Question 22 (Group 21 & 22)
Underworld plc is a manufacturer of computer games. It is currently financed by a mixture of debt and
equity as follows:
Book value
£000s
1 million £1 ordinary shares
Retained earnings
10,000 £100 9.5% irredeemable debentures
1,000
1,978
1,000
Loan repayable in 2025 at 16% fixed interest rate
250
The market price of ordinary shares is £3.35, and the debentures have a market price of £94. The company
pays corporation tax at a rate of 20%. The current return on government securities is 4%, the average stock
market rate of return is 8% and the company has a beta value of 1.25.
An opportunity has arisen to acquire Freshco Limited, a small company operating in the same industry. It is
forecast that Freshco Ltd will generate a cashflow of £300,000 in the first year following acquisition. This is
forecast to increase by 10% a year for the next four years after which cash flows will decline to £350,000 for
the next two years. Due to the dynamic, constantly changing nature of this sector, cash flows after this are
considered too unreliable to forecast.
Freshco Ltd has 1.5 million ordinary shares currently trading on the stock market at a price of 85 pence
each. It also has debt of £500,000.
The directors of Underworld Plc use the company's weighted average cost of capital to appraise investment
opportunities.
Required:
(a) Calculate Underworld's weighted average cost of capital (WACC).
(b) Using discounted cash flows and Underworld's WACC, calculate the total business value and
shareholder value of Freshco Ltd.
(c) Based on your calculations recommend, with reasons, whether Underworld Plc should purchase
Freshco Ltd.
(d) State any assumptions that you have made in arriving at your answers to parts (a) and (b)
7
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