Director A: Suggests the entity's current WACC is more appropriate.

Director B: Suggests calculating a discount rate using data from $xZ,$ a quoted entity, the

main business of which is film production. Relevant data for this entity is as

follows:

Shares in issue: $400$ million currently quoted at $373$ pence each;

Debt outstanding: $350$ million variable rate bank loan;

Equity beta is $1\mathrm{.}6$

Other relevant information

The risk$-$free rate is estimated at $5\%$ per annum and the return on the

market $12\%$ per annum. These rates are not expected to change in thThe management team of $Z$ works in the capital city of Country $Y,$ which is in the more

prosperous southern part of the country. $Z$ has a manufacturing base on the outskirts of

the capital city.

The management team of $Z$ is enthusiastic to grow the business, but is continually frustrated

by a lack of financial and human resources and marketing network that would enable $Z$ to

expand into international markets. Also, on a personal level, many of the senior managers

own a substantial number of shares in $Z$ and are keen to realise some of their capital gains

and become financially more secure$.$

The computer systems of $Z$ consist of a basic accounting package and an internal network

of PCs$.$ Spreadsheet packages are widely used for budgeting and other financial reporting.

Takeover bid

The directors of $Q$ have approached the directors of $Z$ with a view to making a takeover bid

for $Z.$ A condition of the bid would be the retention of the current management team of $Z,$

who have vital knowledge of the specialist manufacturing techniques required to manufacture

the product range of $Z.$ The directors of $Z$ have been initially quite positive about the bid.

Required:

$($a$)$ Advise the directors of $Q$ and $Z$ on the potential problems of merging the

management structure and systems of the two entities and how these could be

minimised.

$(15$ Marks$)$

$($b$)$ Discuss the interrelationship between financing decisions and, investment and

dividend decisions. Illustrate your answer with reference to $Q$ and $Z.(10$ marks$)$

QUESTION $4[25$ MARKS$]$

$AC$ is an entity based in the UK with diverse international interests. Its shares and

debenture stock are quoted on a major international stock exchange. $AC$ is evaluating an

investment in the production and distribution of films and videos, an area in which it has

not previously been involved. This investment will require $600$ million to purchase

premises, equipment and working capital. An alternative approach would be to acquire a

small entity in this field but a preliminary search has revealed none suitable.

Extracts from the most recent balance sheet at $AC$ are shown below:

$$million

ASSETS

Non$-$current assets $,1,920$

Current assets $,1,{880}_{?}$

$3,{800}_{?}$

EQUALITIES AND LIABILITIES

Equity

Share capital $($Shares of $1),300$

Retained earnings $,1,{000}_{?}$

Non$-$current liabilities

$8*4\%$ secured debenture repayable $2012,1,100$

Current liabilities $,1,400$

$3,{800}_{?}$

AC proposes to finance the $600$ million investment with a combination of debt and equity

as follows:

$260$ million in debt paying interest at $8\%$ per annum, secured on the new

premises and repayable in $2024$;

$340$ million in equity via a rights issue. A discount of $15\%$ on the current

share price is likely.

A marginally positive NPV of the proposed investment has been calculated using a discount

rate of $15\%.$ This is the entity's cost of equity plus a small "premium", a rate judged to

reflect the risk of this venture. The Chief Executive of AC thinks this is too marginal and is

doubtful whether the investment should go ahead. However, there is some disagreement

among the Directors about how this project was evaluated, in particular about the discount

rate that has been used.

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