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Underworld plc is a manufacturer of computer games. It is currently financed by a mixture of debt and equity as follows: £000s 1,000 1,978 1,000 Book value 1 million £1 ordinary shares Retained earnings 10,000 £100 9.5% irredeemable debentures 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)

Underworld plc is a manufacturer of computer games. It is currently financed by a mixture of debt and equity as follows: £000s 1,000 1,978 1,000 Book value 1 million £1 ordinary shares Retained earnings 10,000 £100 9.5% irredeemable debentures 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)

Intermediate Financial Management (MindTap Course List)
Intermediate Financial Management (MindTap Course List)
13th Edition
ISBN:9781337395083
Author:Eugene F. Brigham, Phillip R. Daves
Publisher:Eugene F. Brigham, Phillip R. Daves
Chapter15: Distributions To Shareholders: Dividends And Repurchases
Section: Chapter Questions
Problem 6MC: Suppose IWT has decided to distribute $50 million, which it presently is holding in liquid...
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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 1,000 1,978 1,000 10,000 £100 9.5% irredeemable debentures 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)
Transcribed Image Text: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 1,000 1,978 1,000 10,000 £100 9.5% irredeemable debentures 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)
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