Assume that the current date is 30 November 2019.

Rococo plc (Rococo) is a major international hotel operator. At a recent board meeting it was decided that the company should diversify by opening gymnasiums in or near to all of its hotels at a cost of 1,000 million. The following is an extract from the board minutes relating to this diversification:

• The board discussed how the finance would be raised for this diversification as Rococos current gearing (measured as debt/equity by market values) is close to the hotel market average. Some directors felt that gearing is irrelevant and wanted all the finance to be raised from debt. Others were less sure and expressed concern that the companys credit rating would fall, affecting Rococos cost of debt and the market value of its debentures. They preferred a mix of equity and debt or even all equity finance.

The finance director of Rococo was asked to prepare a report on the above issues for presentation at the next board meeting. An extract from Rococos most recent management accounts is shown below:

Balance sheet at 30 November 2019

m

Ordinary share capital (1 shares) 190

Retained earnings 6,000

6,190

4% Redeemable debentures 1,500

7,690

On 30 November 2019 Rococos ordinary shares each had a market value of 46 (ex-div). Rococos debentures are redeemable at par (100) in four years time and the current market price of the debentures is 94 (ex-int).

Total dividends for the years to 30 November:
	2015 m	2016 m	2017 m	2018 m	2019 m
Ordinary dividends	105	93	110	137	141

Other information and assumptions:

• The number of Rococos ordinary shares in issue has not changed in the last five years.

• Corporation tax is at the rate of 17% for the foreseeable future.
• An analyst estimated the following:

(1) If Rococo were to fund the 1,000 million diversification entirely by borrowing the market value of its existing debentures would fall by 5%.

(2) If Rococo were to fund the 1,000 million diversification entirely by equity the market value of its existing debentures would rise by 5%.

(3) The price of the companys ordinary shares would stay the same whether the project is funded entirely by debt or entirely by equity.

Requirements

(a) Calculate on 30 November 2019 Rococos WACC using the dividend valuation model (growth is to be estimated using the earliest and latest dividends)

(10 marks)

(b) Assuming the 1,000 million finance required is raised on 1 December 2019 and taking account of the analysts estimates, calculate Rococos gearing (measured as debt/equity by market values) if it comes entirely from:

(i) debt or

(ii) equity (4 marks)

(c) Discuss whether the 1,000 million finance required for the diversification should be raised from debt, equity or a combination of debt and equity sources. You should make reference to:

• relevant capital structure theories
• Rococos current gearing
• your calculations in (b) above
• other relevant practical issues. (11 marks)

(Total: 25 marks)