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MesmerMagic Co (MMC) is considering whether to undertake the development of a new computer game based on an adventure film due to be released in 22 months. It is expected that the game will be available to buy two months after the film’s release, by which time it will be possible to judge the popularity of the film with a high degree of certainty. However, at present, there is considerable uncertainty about whether the film, and therefore the game, is likely to be successful. Although MMC would pay for the exclusive rights to develop and sell the game now, the directors are of the opinion that they should delay the decision to produce and market the game until the film has been released and the game is available for sale.<br>MMC has forecast the following end of year cash flows for the four-year sales period of the game.<br>MMC will spend $7 million at the start of each of the next two years to develop the game, the gaming platform, and to pay for the exclusive rights to develop and sell the game. Following this, the company will require $35 million for production, distribution and marketing costs at the start of the four-year sales period of the game.<br>It can be assumed that all the costs and revenues include inflation. The relevant cost of capital for this project is 11% and the risk free rate is 3·5%. MMC has estimated the likely volatility of the cash flows at a standard deviation of 30%.<br>Required:<br>(a) Estimate the financial impact of the directors’ decision to delay the production and marketing of the game. The Black-Scholes Option Pricing model may be used, where appropriate. All relevant calculations should be shown. (12 marks)<br>(b) Briefly discuss the implications of the answer obtained in part (a) above. (5 marks)
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Casasophia Co, based in a European country that uses the Euro (€), constructs and maintains advanced energy efficient commercial properties around the world. It has just completed a major project in the USA and is due to receive the final payment of US$20 million in four months.<br>Casasophia Co is planning to commence a major construction and maintenance project in Mazabia, a small African country, in six months’ time. This government-owned project is expected to last for three years during which time Casasophia Co will complete the construction of state-of-the-art energy efficient properties and provide training to a local Mazabian company in maintaining the properties. The carbon-neutral status of the building project has attracted some grant funding from the European Union and these funds will be provided to the Mazabian government in Mazabian Shillings (MShs).<br>Casasophia Co intends to finance the project using the US$20 million it is due to receive and borrow the rest through a € loan. It is intended that the US$ receipts will be converted into € and invested in short-dated treasury bills until they are required. These funds plus the loan will be converted into MShs on the date required, at the spot rate at that time.<br>Mazabia’s government requires Casasophia Co to deposit the MShs2·64 billion it needs for the project, with Mazabia’s central bank, at the commencement of the project. In return, Casasophia Co will receive a fixed sum of MShs1·5 billion after tax, at the end of each year for a period of three years. Neither of these amounts is subject to inflationary increases. The relevant risk adjusted discount rate for the project is assumed to be 12%.<br>Financial Information<br>Exchange Rates available to Casasophia<br>Mazabia’s current annual inflation rate is 9·7% and is expected to remain at this level for the next six months. However, after that, there is considerable uncertainty about the future and the annual level of inflation could be anywhere between 5% and 15% for the next few years. The country where Casasophia Co is based is expected to have a stable level of inflation at 1·2% per year for the foreseeable future. A local bank in Mazabia has offered Casasophia Co the opportunity to swap the annual income of MShs1.5 billion receivable in each of the next three years for Euros, at the estimated annual MShs/€ forward rates based on the current government base rates.<br>Required:<br>(a) Advise Casasophia Co on, and recommend, an appropriate hedging strategy for the US$ income it is due to receive in four months. Include all relevant calculations. (15 marks)<br>(b) Provide a reasoned estimate of the additional amount of loan finance Casasophia Co needs to obtain to undertake the project in Mazabia in six months. (5 marks)<br>(c) Given that Casasophia Co agrees to the local bank’s offer of the swap, calculate the net present value of the project, in six months’ time, in €. Discuss whether the swap would be beneficial to Casasophia Co. (10 marks)
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Section A – BOTH questions are compulsory and MUST be attempted<br>Pursuit Co, a listed company which manufactures electronic components, is interested in acquiring Fodder Co, an unlisted company involved in the development of sophisticated but high risk electronic products. The owners of Fodder Co are a consortium of private equity investors who have been looking for a suitable buyer for their company for some time. Pursuit Co estimates that a payment of the equity value plus a 25% premium would be sufficient to secure the purchase of Fodder Co. Pursuit Co would also pay off any outstanding debt that Fodder Co owed. Pursuit Co wishes to acquire Fodder Co using a combination of debt finance and its cash reserves of $20 million, such that the capital structure of the combined company remains at Pursuit Co’s current capital structure level.<br>Information on Pursuit Co and Fodder Co<br>Pursuit Co<br>Pursuit Co has a market debt to equity ratio of 50:50 and an equity beta of 1·18. Currently Pursuit Co has a total firm value (market value of debt and equity combined) of $140 million.<br>Fodder Co, Income Statement Extracts<br>Fodder Co has a market debt to equity ratio of 10:90 and an estimated equity beta of 1·53. It can be assumed that its tax allowable depreciation is equivalent to the amount of investment needed to maintain current operational levels. However, Fodder Co will require an additional investment in assets of 22c per $1 increase in sales revenue, for the next four years. It is anticipated that Fodder Co will pay interest at 9% on its future borrowings.<br>For the next four years, Fodder Co’s sales revenue will grow at the same average rate as the previous years. After the forecasted four-year period, the growth rate of its free cash flows will be half the initial forecast sales revenue growth rate for the foreseeable future.<br>Information about the combined company<br>Following the acquisition, it is expected that the combined company’s sales revenue will be $51,952,000 in the first year, and its profit margin on sales will be 30% for the foreseeable futue. After the first year the growth rate in sales revenue will be 5·8% per year for the following three years. Following the acquisition, it is expected that the combined company will pay annual interest at 6·4% on future borrowings.<br>The combined company will require additional investment in assets of $513,000 in the first year and then 18c per $1 increase in sales revenue for the next three years. It is anticipated that after the forecasted four-year period, its free cash flow growth rate will be half the sales revenue growth rate.<br>It can be assumed that the asset beta of the combined company is the weighted average of the individual companies’ asset betas, weighted in proportion of the individual companies’ market value.<br>Other information<br>The current annual government base rate is 4·5% and the market risk premium is estimated at 6% per year. The relevant annual tax rate applicable to all the companies is 28%.<br>SGF Co’s interest in Pursuit Co<br>There have been rumours of a potential bid by SGF Co to acquire Pursuit Co. Some financial press reports have suggested that this is because Pursuit Co’s share price has fallen recently. SGF Co is in a similar line of business as Pursuit Co and until a couple of years ago, SGF Co was the smaller company. However, a successful performance has resulted in its share price rising, and SGF Co is now the larger company.<br>The rumours of SGF Co’s interest have raised doubts about Pursuit Co’s ability to acquire Fodder Co. Although SGF Co has made no formal bid yet, Pursuit Co’s board is keen to reduce the possibility of such a bid. The Chief Financial Officer has suggested that the most effective way to reduce the possibility of a takeover would be to distribute the $20 million in its cash reserves to its shareholders in the form. of a special dividend. Fodder Co would then be purchased using debt finance. He conceded that this would increase Pursuit Co’s gearing level but suggested it may increase the company’s share price and make Pursuit Co less appealing to SGF Co.<br>Required:<br>Prepare a report to the Board of Directors of Pursuit Co that<br>(i) Evaluates whether the acquisition of Fodder Co would be beneficial to Pursuit Co and its shareholders. The free cash flow to firm method should be used to estimate the values of Fodder Co and the combined company assuming that the combined company’s capital structure stays the same as that of Pursuit Co’s current capital structure. Include all relevant calculations; (16 marks)<br>(ii) Discusses the limitations of the estimated valuations in part (i) above; (4 marks)<br>(iii) Estimates the amount of debt finance needed, in addition to the cash reserves, to acquire Fodder Co and concludes whether Pursuit Co’s current capital structure can be maintained; (3 marks)<br>(iv) Explains the implications of a change in the capital structure of the combined company, to the valuation method used in part (i) and how the issue can be resolved; (4 marks)<br>(v) Assesses whether the Chief Financial Officer’s recommendation would provide a suitable defence against a bid from SGF Co and would be a viable option for Pursuit Co. (5 marks)<br>Professional marks will be awarded in question 1 for the format, structure and presentation of the report. (4 marks)
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？？Section A – BOTH questions are compulsory and MUST be attempted？？<br>The Seal Island Nuclear Power Company has received initial planning consent for an Advanced Boiling Water Reactor. This project is one of a number that has been commissioned by the Government of Roseland to help solve the energy needs of its expanding population of 60 million and meet its treaty obligations by cutting CO2 emissions to 50% of their 2010 levels by 2030.<br>The project proposal is now moving to the detailed planning stage which will include a full investment appraisal within the financial plan. The financial plan so far developed has been based upon experience of this reactor design in Japan, the US and South Korea.<br>The core macro economic assumptions are that Roseland GDP will grow at an annual rate of 4% (nominal) and inflation will be maintained at the 2% target set by the Government.<br>The construction programme is expected to cost $1 billion over three years, with construction commencing in January 2012. These capital expenditures have been projected, including expected future cost increases, as follows:<br>Generation of electricity will commence in 2015 and the annual operating surplus in cash terms is expected to be $100 million per annum (at 1 January 2015 price and cost levels). This value has been well validated by preliminary studies and includes the cost of fuel reprocessing, ongoing maintenance and systems replacement as well as the continuing operating costs of running the plant. The operating surplus is expected to rise in line with nominal GDP growth. The plant is expected to have an operating life of 30 years.<br>Decommissioning costs at the end of the project have been estimated at $600 million at current (2012) costs. Decommissioning costs are expected to rise in line with nominal GDP growth.<br>The company’s nominal cost of capital is 10% per annum. All estimates, unless otherwise stated, are at 1 January 2012 price and cost levels.<br>Required:<br>Produce a preliminary briefing note which, on the basis of the above information, includes:<br>(i) An estimate of the net present value for this project as at the commencement of construction in 2012. (11 marks)<br>(ii) A discussion of the principal uncertainties associated with this project. (7 marks)<br>(iii) A sensitivity of the project’s net present value (in percentage and in $), to changes in the construction cost, the annual operating surplus and the decommissioning cost. (Assume that the increase in construction costs would be proportional to the initial investment for each year.) (6 marks)<br>(iv) An explanation of how simulations, such as the Monte Carlo simulation, could be used to assess the volatility of the net present value of this project. (4 marks)<br>Note: the formula for an annuity discounted at an annual rate (i) and where cash flows are growing at an annual rate (g) is as follows:
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Section A – BOTH questions are compulsory and MUST be attempted<br>Coeden Co is a listed company operating in the hospitality and leisure industry. Coeden Co’s board of directors met recently to discuss a new strategy for the business. The proposal put forward was to sell all the hotel properties that Coeden Co owns and rent them back on a long-term rental agreement. Coeden Co would then focus solely on the provision of hotel services at these properties under its popular brand name. The proposal stated that the funds raised from the sale of the hotel properties would be used to pay off 70% of the outstanding non-current liabilities and the remaining funds would be retained for future investments.<br>The board of directors are of the opinion that reducing the level of debt in Coeden Co will reduce the company’s risk and therefore its cost of capital. If the proposal is undertaken and Coeden Co focuses exclusively on the provision of hotel services, it can be assumed that the current market value of equity will remain unchanged after implementing the proposal.<br>Coeden Co Financial Information<br>Extract from the most recent Statement of Financial Position<br>Coeden Co’s latest free cash flow to equity of $2,600,000 was estimated after taking into account taxation, interest and reinvestment in assets to continue with the current level of business. It can be assumed that the annual reinvestment in assets required to continue with the current level of business is equivalent to the annual amount of depreciation. Over the past few years, Coeden Co has consistently used 40% of its free cash flow to equity on new investments while distributing the remaining 60%. The market value of equity calculated on the basis of the free cash flow to equity model provides a reasonable estimate of the current market value of Coeden Co.<br>The bonds are redeemable at par in three years and pay the coupon on an annual basis. Although the bonds are not traded, it is estimated that Coeden Co’s current debt credit rating is BBB but would improve to A+ if the non-current liabilities are reduced by 70%.<br>Other Information<br>Coeden Co’s current equity beta is 1·1 and it can be assumed that debt beta is 0. The risk free rate is estimated to be 4% and the market risk premium is estimated to be 6%.<br>There is no beta available for companies offering just hotel services, since most companies own their own buildings. The average asset beta for property companies has been estimated at 0·4. It has been estimated that the hotel services business accounts for approximately 60% of the current value of Coeden Co and the property company business accounts for the remaining 40%.<br>Coeden Co’s corporation tax rate is 20%. The three-year borrowing credit spread on A+ rated bonds is 60 basis points and 90 basis points on BBB rated bonds, over the risk free rate of interest.<br>Required: (a) Calculate, and comment on, Coeden Co’s cost of equity and weighted average cost of capital before and after implementing the proposal. Briefly explain any assumptions made. (20 marks) (b) Discuss the validity of the assumption that the market value of equity will remain unchanged after the implementation of the proposal. (5 marks) (c) As an alternative to selling the hotel properties, the board of directors is considering a demerger of the hotel services and a separate property company which would own the hotel properties. The property company would take over 70% of Coeden Co’s long-term debt and pay Coeden Co cash for the balance of the property value. Required: Explain what a demerger is, and the possible benefits and drawbacks of pursuing the demerger option as opposed to selling the hotel properties. (8 marks)
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1 Sleepon Hotels plc owns a successful chain of hotels. The company is considering diversifying its activities through the construction of a theme park near London. The theme park would have a mixture of family activities and adventure rides. Sleepon has just spent ￡230,000 on market research into the theme park, and is encouraged by the findings.<br>The theme park is expected to attract an average of 15,000 visitors per day for at least four years, after which major new investment would be required in order to maintain demand. The price of admission to the theme park is expected to be ￡18 per adult and ￡10 per child. 60% of visitors are forecast to be children. In addition to admission revenues,<br>it is expected that the average visitor will spend ￡8 on food and drinks, (of which 30% is profit), and ￡5 on gifts and souvenirs, (of which 40% is profit). The park would open for 360 days per year.<br>All costs and receipts (excluding maintenance and construction costs and the realisable value) are shown at current prices; the company expects all costs and receipts to rise by 3% per year from current values.<br>The theme park would cost a total of ￡400 million and could be constructed and working in one year’s time. Half of the ￡400 million would be payable immediately, and half in one year’s time. In addition working capital of ￡50 million will be required from the end of year one. The after tax realisable value of fixed assets is expected to be between ￡250 million and ￡300 million after four years of operation.<br>Maintenance costs (excluding labour) are expected to be ￡15 million in the first year of operation, increasing by ￡4 million per year thereafter. Annual insurance costs are ￡2 million, and the company would apportion ￡2·5 million per year to the theme park from existing overheads. The theme park would require 1,500 staff costing a total of ￡40 million per annum (at current prices). Sleepon will use the existing advertising campaigns for its hotels to also advertise the theme park. This will save approximately ￡2 million per year in advertising expenses.<br>As Sleepon has no previous experience of theme park management, it has investigated the current risk and financial structure of the closest UK theme park competitor, Thrillall plc. Details are summarised below.<br>Thrillall plc, summarised balance sheet<br>Other information:<br>(i) Sleepon has access to a ￡450 million Eurosterling loan at 7·5% fixed rate to provide the necessary finance for the theme park.<br>(ii) ￡250 million of the investment will attract 25% per year capital allowances on a reducing balance basis.<br>(iii) Corporate tax is at a rate of 30%.<br>(iv) The average stock market return is 10% and the risk free rate 3·5%.<br>(v) Sleepon’s current weighted average cost of capital is 9%.<br>(vi) Sleepon’s market weighted gearing if the theme park project is undertaken is estimated to be 61·4% equity,<br>38·6% debt.<br>(vii) Sleepon’s equity beta is 0·70.<br>(viii) The current share price of Sleepon is 148 pence, and of Thrillall 386 pence.<br>(ix) Thrillall’s medium and long term debt comprises long term bonds with a par value of ￡100 and current market price of ￡93.<br>(x) Thrillall’s equity beta is 1·45.<br>Required:<br>Prepare a report analysing whether or not Sleepon should undertake the investment in the theme park. Your report should include a discussion of what other information would be useful to Sleepon in making the investment decision. All relevant calculations must be included in the report or as an appendix to it. State clearly any assumptions that you make.<br>(Approximately 28 marks are available for calculations and 12 for discussion)<br>(40 marks)
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